What is a Derivative Tool? Trading Guide and How to Profit from the Derivatives Market

Starting from History: Derivatives Instruments Are Not New

Derivatives securities (derivatives) have a much longer history than you think. The first futures contracts appeared in the second century BC in ancient Mesopotamia. However, they only became widely used from the 1970s after modern pricing techniques were developed. Today, it’s hard to imagine a modern financial system without derivatives tools.

What Are Derivatives Instruments?

Derivatives securities are a type of financial contract whose value depends directly on an underlying asset. This underlying asset can be:

• Physical commodities: crude oil, gold, silver, agricultural products
• Financial assets: stocks, bonds, stock indices
• Other factors: interest rates, foreign exchange

When the price of the underlying asset changes, the value of the related derivative instrument also fluctuates accordingly. This is also why pricing derivatives is much more complex than other financial instruments.

Main Types of Derivatives Securities

The derivatives market includes 4 basic contract types, each with its own characteristics:

Forward Contract (Forward): An agreement between two parties to buy or sell a certain amount of an asset at a predetermined price, with settlement at expiration. No intermediary organization is involved, resulting in low costs but no control.

Futures Contract (Future): A standardized version of Forward listed on stock exchanges. Prices are marked to market daily, both parties must post margin, and it has higher liquidity.

Option Contract (Option): Provides the right (not the obligation) to buy or sell an asset at a specified price within a certain timeframe. This is the most modern tool, allowing investors to better control risks.

Swap Contract (Swap): A transaction between two parties exchanging one stream of payments for another, calculated based on certain principles. Usually traded over-the-counter (OTC).

Two Main Channels for Derivatives Trading

OTC Market (Over-the-Counter): Contracts are executed directly between two parties, not regulated by the government. The advantage is low cost due to the absence of third parties, but the risk is that one party may default at settlement.

Regulated Exchange: Derivative instruments must be approved before listing. Although transaction fees are higher, participants’ rights and obligations are protected.

The Most Widely Used Derivatives Instruments

CFD (Contract for Difference): An agreement between two parties (investors and brokers) to pay the difference in the price of an asset from opening to closing. CFDs have no expiration date, can be closed at any time, apply to over 3000 commodities, use high leverage, and have low costs.

Option (Option): Grants the right to buy or sell an asset at a predetermined price. Has a contract duration, can only be closed before or on the expiration date. Large trading volume, higher fees than CFDs, but with stricter regulations.

Derivatives Trading Process

Step 1 - Choose a reputable exchange

Selecting a trustworthy exchange is a crucial foundation. A reputable platform helps you avoid the risk of one party defaulting.

Step 2 - Open a trading account

After choosing an exchange, register for a derivatives trading account.

Step 3 - Deposit initial margin

The margin amount depends on the quantity of assets you want to buy and the leverage level you use.

Step 4 - Place a trading order

Based on your analysis, place a Long (predict price increase) or Short (predict price decrease) order via the trading app.

Step 5 - Manage your position

Monitor your position, take profit when the market is favorable, or cut losses to control risk.

Real Example: Profit from Gold Price Volatility

Suppose the current gold price is at a high ($1683/oz) and based on your experience, you predict that after economic stabilization, gold prices will drop sharply. You do not own physical gold but want to profit from this decline, so you use a gold CFD.

Open a Short Position:

Since you expect the price to fall, you open a Short position — meaning you “sell” gold at the current $1683/oz. When the price actually drops to $1660, you close the position by buying back, thus earning the difference.

Use leverage to maximize profit:

With limited capital, you decide to use 1:30 leverage. This means the initial capital needed is only $56.1 instead of $1683 to control 1 oz of gold.

Compare the results:

If the gold price drops to $1660:

• With 1:30 leverage: You earn $23, equivalent to a 41% profit on initial capital
• Without leverage: You earn $23, equivalent to a 1.36% profit on initial capital

If the gold price rises $1700 (wrong prediction):

• With 1:30 leverage: You lose $17, equivalent to 30% of initial capital
• Without leverage: You lose $17, equivalent to 1% of initial capital

As you can see, leverage is a double-edged sword — it amplifies both profits and losses.

Benefits of Derivatives Trading

Hedging (Hedging): Derivatives were initially created for protection. An investor can buy an asset that moves inversely to their current holdings, so profits from derivatives offset losses from the underlying asset.

Supporting asset valuation: The spot prices of futures contracts can help approximate the real market value of commodities.

Enhancing market efficiency: Through derivatives trading, investors can replicate the payout profile of an asset. As a result, the prices of the underlying assets and related derivatives tend to balance, avoiding arbitrage opportunities.

Expanding access opportunities: Using interest rate swaps, a company can obtain more favorable interest rates than direct borrowing.

Risks Associated with Derivatives

Extreme price volatility: The sophisticated design of contracts makes valuation extremely complex. Therefore, high risk is an inherent characteristic of derivatives.

Speculative tools: Due to high risk and volatility, prices are unpredictable. Reckless speculation can lead to huge losses.

Counterparty risk (Counterparty Risk): If trading OTC, the other party may default at settlement.

Who Should Trade Derivatives?

Commodity producers: Companies extracting oil, gold, or other commodities can use futures contracts to lock in prices and hedge against price fluctuations.

Hedge funds and trading firms: Use derivatives as a shield to protect positions or to enhance portfolio management.

Individual traders and investors: Use derivatives for speculation on an asset and leverage to increase profits.

In summary, derivatives securities are powerful tools with high profit potential but also significant risks. Success in derivatives trading requires deep understanding, disciplined trading, and strict risk management.