What Are Derivatives? A Detailed Guide to Trading Derivative Instruments and Making Money from the Market

Basic Concepts: What Are Derivatives?

Derivative tools (derivatives) are not a new concept in the world of finance. Since ancient times in Mesopotamia from the second millennium BC, parties have used the earliest futures contracts to lock in prices. However, this market only truly exploded in the 1970s when modern pricing methods were developed.

What are derivatives? They are financial instruments whose value depends directly on the price of another underlying asset. This underlying asset can be commodities (crude oil, gold, silver, agricultural products), financial instruments (stocks, bonds), indices (US500), or even interest rates. When the underlying asset fluctuates, the price of the derivative instrument will also change accordingly, making valuation much more complex than traditional financial products.

Today, it is unimaginable to have a modern financial system without the presence of derivatives.

Main Types of Derivative Securities

The derivatives market is highly diverse, with each instrument having its own characteristics. Here are the four most common types of derivative securities:

Forward Contract (Forward): An agreement between two parties to buy or sell a specific amount of underlying asset at a predetermined price, with settlement date set in the future. The parties trade directly without intermediaries or fees, but settlement occurs as scheduled.

Futures Contract (Future): Essentially similar to forward contracts but standardized and officially listed on stock exchanges. Advantages include high liquidity, daily price updates, and margin requirements to ensure payment ability. Contract values are also marked-to-market daily according to market prices.

Option (Option): The only instrument that gives the buyer the right (not obligation) to buy or sell the underlying asset at a certain price within a specified timeframe. As a rights-based instrument, options have their own value. Prices are determined based on the underlying asset’s price through complex valuation formulas.

Swap (Swap): Transactions between two parties involving a buy contract and a sell contract to exchange cash flows, calculated based on certain principles. This type of contract is often traded outside centralized markets and cannot be bought or sold like regular securities; they are private agreements between two parties.

Two Ways to Trade Derivative Securities

Traders can access derivatives through two main channels:

Over-The-Counter (OTC) Trading (Over-The-Counter): These are private contracts between two parties without strict oversight. The advantage is low transaction costs due to no intermediaries, but the downside is high risk of counterparty default at maturity.

Exchange-Traded Trading: Derivative instruments must undergo rigorous approval processes before being listed. Contract participants are protected by law regarding rights and obligations, but transaction fees tend to be higher.

Most Widely Used Derivative Instruments

Among available tools, two stand out:

CFD (Contract for Difference): CFDs are agreements between traders and brokers to settle the difference in the price of an asset between opening and closing positions. They are the most trusted OTC instruments because they involve direct counterparty risk. CFDs have unlimited duration contracts, allow closing positions at any time, cover over 3000 different commodities, use high leverage requiring low initial capital, and have extremely low transaction costs compared to options.

Options: Provide traders the right (not obligation) to buy or sell an asset at a specified price within a certain timeframe. This is the most modern instrument among listed derivatives. Options have fixed-term contracts, can only be closed before or at expiration, are only available for regulated commodities, support large-scale trading models, but also have higher transaction fees.

It is important to note that each instrument’s price movement differs. For options, moving one point in the underlying asset does not necessarily equal one point in the contract price, whereas for CFDs, prices always closely track the underlying asset.

Detailed Process to Start Trading Derivatives

Step 1 - Open an account: Investors need to choose a reputable trading platform and register an account. Choosing a trustworthy platform is crucial because it protects you from counterparty risk.

Step 2 - Deposit margin: Depending on the volume of commodities you wish to trade and the leverage level you select, deposit an appropriate margin into your account.

Step 3 - Place trading orders: After depositing funds, you can start trading. Based on your market predictions, place Long (predict price increase) or Short (predict price decrease) orders via mobile app or web version.

Step 4 - Manage positions: Monitor your positions, take profits when reaching your target gains, and cut losses when necessary to limit damages.

Real-Life Example: Making Money from Gold Price Fluctuations

Suppose gold is currently at a peak of $1683/oz. Based on your experience and analysis, you predict gold will drop sharply as the economic situation stabilizes. Although you do not own physical gold, you can profit from this volatility by trading CFD gold.

Open a Short Position: Since you expect the price to fall, open a Short position by selling gold at the current $1683/oz. When the price drops as predicted to $1660/oz, close the position by buying back, earning a profit of $23/oz.

Use leverage to increase profits: Because the $1683/oz gold price is high relative to your initial capital, you decide to use 1:30 leverage. This means you only need to put up $56.1 instead of $1683 to buy 1 oz(. When the gold price drops to $1660, you gain $23, equivalent to a 41% profit on your capital—30 times higher than without leverage )only 1.36%$1700 .

However, leverage doubles the risk. If the gold price rises instead of falling, you will lose $17, equivalent to 30% of your initial capital (compared to 1% without leverage).

Benefits of Trading Derivatives

It’s no surprise that derivatives are widely traded in global financial markets. This market offers significant advantages:

Hedging risk: The original purpose of derivatives is to help investors protect their portfolios. By buying an asset that moves inversely to their holdings, profits from derivatives can offset losses in the underlying assets.

Fair valuation of underlying assets: The spot price of futures contracts can reflect the approximate real commodity price, aiding in fair valuation.

Market efficiency enhancement: Through derivatives, payment streams of assets can be replicated. As a result, the prices of the underlying assets and related derivatives tend to stay in balance, preventing arbitrage opportunities.

Access to favorable assets: Using interest rate swaps, companies can obtain better interest rates than direct bank loans.

Risks to Be Aware Of

Like any financial product, trading derivatives involves certain risks:

High price volatility: Derivative instruments are inherently highly volatile, capable of causing significant losses. The sophisticated design of contracts makes valuation extremely complex or even impossible, which is a characteristic of any derivative.

Speculative tools: Due to their high risk and large price swings, derivative prices are difficult to predict. Reckless speculation can lead to devastating losses.

Counterparty risk in OTC markets: If trading on decentralized platforms, you face the risk that the counterparty may default at maturity, due to lack of strict oversight.

Valuation difficulties: Listed contracts must pass rigorous approval processes; if they do not meet standards, they are traded OTC with higher risks.

Who Should Trade Derivatives?

Different groups can benefit from derivative instruments:

Commodity producers: Companies extracting crude oil, gold, Bitcoin, or other commodities can use futures or swaps to lock in selling prices, thus hedging against unwanted price fluctuations.

Hedge funds and trading firms: These organizations use derivatives to leverage, protect positions, or enhance portfolio management strategies.

Individual traders: Retail traders and investors use derivatives to speculate on various assets, often combined with leverage to increase profit potential.

Today, the derivatives industry has become an essential part of the global financial system, serving the diverse needs of many market participants.