## Derivatives Market - Modern Financial Instruments You Need to Understand Clearly

What are derivatives? This is a question many traders ask when they first start exploring the financial markets. In fact, derivative instruments have existed for thousands of years. Since Mesopotamian times, the first forward contracts appeared to help merchants manage risk. However, derivatives truly exploded in the 1970s with the advent of modern pricing models. Today, no financial market can develop without the participation of derivative tools.

## Definition of Derivative Instruments

A derivative is a type of asset whose value is determined by the fluctuations of another underlying asset. This underlying asset can be tangible commodities such as oil, precious metals, or agricultural products, or abstract financial instruments like stocks, bonds, market indices, or interest rates.

When the price of the underlying asset changes, the price of the derivative instrument will also fluctuate accordingly. This makes valuation more complex compared to traditional financial tools because you must calculate based on the volatility of another asset.

## Main Types of Derivative Instruments

The derivatives market includes many different instruments, each with its own characteristics:

### Forward Contract (

This is an agreement between two parties to buy or sell a fixed amount of an asset at an agreed-upon price, with a predetermined settlement date. The feature of a forward contract is that it involves no intermediary, with both parties trading directly with each other without fees, and settlement occurs on the specified date.

) Futures Contract ###

A futures contract is a standardized version of a forward contract, listed and traded publicly on stock exchanges. These contracts are much more liquid because prices are updated daily according to market prices. Participants are required to deposit margin to ensure settlement ability.

( Options Contract )

Options are unique instruments because they give the holder the ###right, not obligation(, to buy or sell the underlying asset at a specified price within a certain period. Due to this flexibility, options have their own value and are among the most modern derivative tools.

) Swap Contract (

Swaps are agreements between two parties to exchange cash flows calculated based on certain principles. These contracts are often traded OTC - over-the-counter ).

## Two Main Trading Channels

### OTC Trading (Over-The-Counter )

OTC derivative instruments are private contracts between two parties without oversight from a national organization. The advantage is low cost due to the absence of third-party intermediaries, but the risk is that if one party fails to fulfill the contract, significant losses may occur.

( Regulated Exchange Trading )

Exchange-traded derivatives are regulated by the government and must go through strict approval processes. Although transaction fees are higher, the rights of the participants are fully protected.

## The Most Used Derivative Instruments

### CFD - Contract for Difference (

A CFD is an agreement between a trader and a broker to exchange the price difference of an asset from the time the position is opened until it is closed. CFDs have the following features:

- No expiration date, can be closed at any time
- Can trade over 3000 different assets
- Use high leverage, reducing the initial capital required
- Lower transaction costs compared to other tools
- Price always closely follows the underlying asset

) Options ###

Options are regulated derivative instruments traded on exchanges, providing the ###right, not obligation###, to buy or sell an asset at a fixed price within a certain period. Features include:

- Contracts with clear expiration dates
- Positions can only be closed before or on the expiration date
- Only approved assets have options contracts
- Large trading volume but higher transaction fees
- More complex valuation than CFDs

**Important comparison:** With CFDs, when the underlying asset changes by 1 point, the CFD price also changes by 1 point. However, with options, a 1-point change in the underlying asset does not necessarily lead to a 1-point change in the option price.

## Steps to Execute Derivative Trading

( Step 1: Open a Trading Account

The first step is to choose a reputable trading platform to open an account. Selecting a well-known broker is crucial as it helps protect your rights and minimizes counterparty risks.

) Step 2: Deposit Margin

After opening an account, you need to deposit an initial margin. The amount depends on the number of assets you want to trade and the leverage you plan to use.

### Step 3: Place Orders

Once you have sufficient margin, you can proceed to place trading orders. Based on your market analysis, you will place a Long ###if you predict prices will rise### or Short (if you predict prices will fall), through an app or web interface.

( Step 4: Manage Positions

After opening a position, you need to monitor the market continuously, decide when to take profit if profitable, or cut losses if the situation turns unfavorable.

## Real-Life Example: Making Money from Gold Trading

Imagine you predict that gold prices will fall after economic conditions stabilize. The current gold price is $1683/oz, and you want to profit from this decline without owning physical gold. You decide to use a derivative instrument.

**Set Up a Short Position:**

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

**Using Leverage:**

You use 1:30 leverage, meaning you only need to put up $56.1 instead of (to control 1 oz of gold).

**Compare Results:**

| Scenario | With 1:30 Leverage | Without Leverage |
|------------|---------------------|------------------|
| Price drops $1683 | Profit $1660 = 41% | Profit $23 = 1.36% |
| Price rises $23 | Loss $1700 = 30% | Loss $17 = 1% |

This example shows how leverage can amplify both profits and losses. When your prediction is correct, profits can reach 41%, but if wrong, you could lose up to 30% of your capital.

## Why Should You Understand Derivatives?

$17 Risk Management ###

The initial reason for derivatives' existence is to help businesses hedge risks. Instead of bearing all the risk from price fluctuations, investors can buy a derivative that moves inversely, offsetting potential losses.

### Asset Price Support ###

The spot price from futures contracts can help determine the fair value of commodities, providing a reference point for the market.

### Market Efficiency Enhancement ###

Through derivatives, it is possible to replicate the payout levels of different assets. This helps keep the prices of the underlying assets and related derivatives in balance, avoiding arbitrage opportunities.

### Access Opportunities ###

Interest rate swaps, for example, allow companies to access better interest rates that they cannot obtain through direct borrowing.

## Risks to Be Aware Of

### High Price Volatility ###

Derivatives are complex instruments with sophisticated designs. This makes valuation extremely difficult or even impossible to predict. Large price swings can lead to significant losses.

### Speculative Nature ###

Due to large price fluctuations, derivatives are often considered speculative tools. If you speculate recklessly, you could lose your entire initial capital.

OTC Contract Risks

If you choose OTC trading, you must accept the risk that your counterparty may not fulfill the contract as agreed.

Regulation and Approval

Derivatives traded on regulated exchanges must go through approval processes. If a contract does not meet standards, it will be transferred to OTC trading, which carries higher risks.

## Who Should Trade Derivatives?

Manufacturing and Commodity Companies

Companies involved in extracting or producing oil, precious metals, or Bitcoin can use futures or swaps to lock in prices and hedge against sudden large price swings.

Portfolio Management Funds

Hedge funds and trading firms use derivatives to manage risks in their portfolios and to enhance performance through leverage.

Individual Traders

Individual traders and investors use derivatives to speculate on assets and leverage to increase their potential profits.

## Conclusion

What are derivatives? They are powerful financial tools that allow trading on price fluctuations without owning the underlying asset. From hedging risks to speculation, from CFDs to options, derivatives offer many ways to participate in the financial markets. However, like all powerful tools, they come with significant risks that you need to understand thoroughly before starting to trade.