## What Are Derivatives in Securities - A Complete Guide for Traders

Financial derivative tools (derivatives) have existed for thousands of years. As early as ancient Mesopotamian times, the first futures contracts appeared. However, they only truly exploded in the 1970s when modern valuation methods were developed. Today, these tools are indispensable in the global financial system.

### What Are Derivatives in Securities?

A derivative (derivative) is a financial instrument whose value depends entirely on the price movements of an underlying asset. This asset can be:

- **Commodities:** crude oil, gold, silver, agricultural products
- **Financial assets:** stocks, bonds
- **Other indices:** stock indices, interest rates

When the underlying asset's price fluctuates, the value of the derivative instrument also changes accordingly. Therefore, derivative valuation is more complex than that of regular financial tools.

### Main Types of Derivative Securities

The derivatives market includes four main instruments, each with its own characteristics:

**Forward Contract (Forward)**
- An agreement between two parties to buy or sell an underlying asset at a predetermined price
- Settlement occurs at the maturity date
- No intermediary organization; no fees involved
- Price varies daily based on market movements

**Futures Contract (Future)**
- A standardized version of the forward contract
- Listed on stock exchanges
- Higher liquidity
- Both parties must post margin to ensure payment capability
- Price determined daily based on market conditions

**Option (Option)**
- Grants the holder the right, but not the obligation, to buy or sell an asset at a predetermined price
- The right is optional — not mandatory
- Option value depends on the market price of the underlying asset
- Usually traded on listed exchanges

**Swap (Swap)**
- A transaction between two parties involving one buy and one sell
- Cash flows are calculated based on predefined principles
- Often traded over-the-counter (OTC)
- A private agreement between two parties

### Two Derivative Trading Channels

**Decentralized OTC Market (OTC)**

This is a direct trading channel between two parties, without centralized regulation. The advantage is low cost due to the absence of intermediaries, but the risk is that one party may default at settlement.

**State-Regulated Exchanges**

Derivative instruments listed here must undergo approval processes before being listed. Trading fees are higher, but the rights of the parties are protected.

### CFD and Options - The Two Most Widely Used Instruments

**CFD (Contract For Difference)**

A CFD is an agreement between a trader and a broker to pay the difference between the opening and closing prices. It is the most popular instrument in the OTC market.

**Options**

Provide the right — not obligation — to buy or sell an asset at a predetermined price within a specified period. This is the most modern instrument on listed exchanges.

**Comparison of CFD and Options:**

| Criteria | CFD | Options |
|---------|-----|-----------|
| **Expiration** | No expiration date; can be closed at any time | Has a deadline; can only be closed before or at expiration |
| **Scope** | Over 3000 commodities | Only regulated commodities |
| **Leverage** | Uses high leverage, low initial capital | Higher transaction costs than CFDs |
| **Price** | Tracks the underlying asset closely | Requires complex valuation formulas |

( Derivative Trading Process

**Step 1: Choose a platform and open an account**

Selecting a reputable trading platform is crucial to avoid counterparty risks. A well-regulated platform will protect your rights.

**Step 2: Deposit initial margin**

The margin amount depends on the type of commodity you want to trade and the leverage level you choose.

**Step 3: Place a trading order**

Based on your market forecast, place a Long )buy### order if you expect prices to rise, or Short (sell) if you expect prices to fall. Orders can be placed via mobile app or web.

**Step 4: Manage your position**

Monitor your position, take profit when your target is reached, or cut losses if the market moves against your forecast.

( Practical Example: Making Money from Gold Price Fluctuations

Suppose the current gold price is at a high of $1683/oz. Based on experience, you forecast a sharp decline as the economic situation stabilizes. You want to capitalize on this without owning physical gold, so you use a gold CFD.

**Open a Short Position**

You open a Short )sell### position at $1683/oz. When the gold price drops to $1660/oz, you close the position by buying back, earning a profit of $23/oz.

**Using 1:30 Leverage**

Instead of risking (per ounce of gold, you only need $56.1 )which is 1/30 of the price$1683 . This allows you to:

- **If your forecast is correct:** Profit (= 41% return on initial capital
- **If your forecast is wrong:** Loss )= 30% of initial capital

This comparison illustrates the power of leverage — it can amplify both profits and risks.

$23 Why Do Investors Use Derivatives in Securities?

**Risk Hedging**

Derivatives were initially created to reduce risk. Investors can buy assets that move inversely to their holdings, offsetting potential losses.

**Estimating Underlying Asset Prices**

The spot price of futures contracts helps approximate the actual market value of commodities.

**Enhancing Market Efficiency**

By replicating asset payoffs through derivatives, the prices of underlying assets and related derivatives tend to balance, preventing unreasonable price gaps.

**Access to Favorable Assets**

Through interest rate swaps, companies can achieve better interest rates than direct borrowing.

$17 Risks of Trading Derivatives

**High Volatility Causing Significant Losses**

The sophisticated design of contracts makes valuation extremely complex. High risk is inherent in derivatives.

**Speculative Nature**

Derivative prices are difficult to predict due to large fluctuations. Unreasonable speculation can lead to substantial losses.

**Liquidity Risks in OTC Markets**

If trading occurs on decentralized platforms, the counterparty may default on the contract.

### Who Should Trade Derivatives?

**Commodity Exploitation Companies**

They can lock in prices for crude oil, gold, Bitcoin they produce, thus hedging against price volatility.

**Hedge Funds and Trading Firms**

Use derivatives to leverage positions or hedge their portfolios, managing investments more effectively.

**Traders and Individual Investors**

Use derivatives for speculation and to increase profits through leverage.

In summary, **what are derivatives in securities**? They are powerful financial tools that allow traders to seize market opportunities, but they also require experience and careful risk management.