Derivatives (Derivatives) tools in Modern Financial Trading: From Theory to Practice

What Are Derivative Securities? Exploring the Nature of an Important Financial Instrument

Derivative instruments have existed in the human economy for a very long time. However, they are not a recent invention. Since ancient times in Mesopotamia, forward contracts for commodity trading appeared with the purpose of stabilizing prices. Nonetheless, the true development of this market only began in the 1970s when mathematical pricing models were developed. Today, derivative securities have become an indispensable part of the global financial system.

In terms of definition, derivative securities are financial products whose value depends directly on the fluctuations of an underlying asset. This underlying asset can be raw commodities such as oil, gold, silver, agricultural products, or financial certificates like stocks, bonds, market indices, or even interest rates. When the price of the underlying asset changes, the value of the related derivative instrument also fluctuates accordingly. This characteristic makes the valuation of derivatives more complex than traditional financial products.

Why Are Derivative Securities Important in the Financial Market?

In today’s global economy, the role of derivatives is increasingly essential. First, they provide an effective mechanism for risk management. By owning a derivative that moves inversely to the main asset held, investors can offset potential losses.

Second, derivatives help determine fair prices for the underlying assets. Futures contracts act as a publicly available price mirror, helping the market understand future price trends.

Third, they enhance market efficiency by creating opportunities for price coordination between the underlying asset and related derivatives. Additionally, through interest rate swaps, companies can access better financial terms compared to direct borrowing.

Main Types of Derivative Securities and Their Characteristics

The derivatives market offers many different instruments, each with its own operating mechanism and properties:

Forward Contracts (Forward) are agreements between two parties to buy or sell a fixed amount of an asset at a predetermined price, settled on a future date. Key features include no intermediaries, no fees, but full credit risk depends on the creditworthiness of the counterparty.

Futures Contracts (Future) are standardized versions of forward contracts, traded openly on stock exchanges. An important difference is that prices are marked-to-market daily, requiring margin deposits from both parties, with the exchange guaranteeing settlement.

Options Contracts (Option) give the holder the right (not an obligation) to buy or sell an asset at a specified price. This tool is unique because its value lies in the right, not the obligation, to execute the transaction.

Swaps (Swap) are agreements to exchange cash flows between two parties based on pre-agreed calculation rules. These contracts are often traded over-the-counter (OTC).

Detailed comparison table:

Two Channels for Trading Derivative Securities

Investors can access derivatives through two main channels:

OTC Trading (Over-the-Counter) occurs outside formal exchanges. Contracts are negotiated directly between two parties and are less regulated. Advantages include lower costs due to no intermediaries, but disadvantages involve default risk from the counterparty.

Exchange-Traded Trading requires all contracts to undergo pre-listing approval processes. Although transaction costs are higher, traders’ rights are protected by the exchange.

CFD and Options: The Two Most Popular Derivative Tools

In practice, the two most widely used tools are:

CFD (Contract for Difference) is an agreement between a trader and a broker to exchange the price difference of an asset between the opening and closing of a position. CFDs are considered the most popular and reliable OTC instruments because they connect investors directly with brokers.

Options give traders the right (but not the obligation) to buy or sell an asset at a predetermined price within a certain period. This is the most advanced tool among exchange-traded derivatives.

Differences between the two:

Step-by-Step Process for Trading Derivative Securities

To start trading derivatives, investors should follow this process:

Step 1: Choose a reputable trading platform and open an account

Selecting a reputable platform is the most important decision. A well-regarded platform will protect you from default risk. Then, proceed to register and open a trading account.

Step 2: Deposit margin and initial capital

The required deposit depends on the quantity of assets you wish to trade and the leverage you plan to use. This amount will serve as collateral for your trades.

Step 3: Market analysis and placing orders

Based on your market analysis, decide whether the market will go up or down. If bullish, place a Long order (mua); if bearish, place a Short order (bán). These orders can be executed via mobile app or web platform.

Step 4: Manage positions and take profit/stop-loss

After opening a position, continuously monitor prices. When prices move in your predicted direction, you can take profit. Conversely, if the market moves against you, set a stop-loss to limit losses.

Real-Life Example: Making Money from Gold Price Fluctuations

Consider a real scenario: Gold is at its all-time high ($1683/oz). Based on experience and analysis, you forecast that after economic stabilization, gold prices will decline significantly. You want to capitalize on this opportunity without owning physical gold. The solution is to use a gold CFD (a derivative instrument based on gold price movements).

Strategy: You open a Short position (sell), selling gold at the current price of $1683/oz. When the price drops as forecasted, you close the position by buying back at a lower price, say $1660/oz, and profit from the $23/oz difference.

Leverage use: Gold prices are too high relative to your capital, so you use 1:30 leverage. This means your initial capital is multiplied 30 times.

Comparison results:

With 1:30 leverage:

• Capital needed: $56.1 to buy 1 oz of gold
• If price drops to $1660: profit of $23, equivalent to 41% of initial capital
• If price rises to $1700: loss of $17, equivalent to 30% of initial capital

Without leverage:

• Capital needed: ( (your own capital)
• If price drops to $1660: profit of $23, about 1.36% of initial capital
• If price rises to $1700: loss of $17, about 1% of initial capital

This example illustrates how leverage can amplify both gains and losses. Therefore, it should be used cautiously with proper risk management.

Potential Risks in Trading Derivative Securities

Although derivatives offer many opportunities, they also come with significant risks:

High price volatility: Derivatives can fluctuate sharply, leading to substantial losses. The complex design of contracts makes valuation extremely difficult, sometimes impossible to predict accurately.

Speculative nature: Due to high volatility, traders may be tempted to speculate. Ill-advised speculative decisions can result in total loss of capital.

Default risk in OTC trading: If trading OTC without regulation, there is a risk that the counterparty may default on the contract.

Complexity: For novice traders, the complexity of these instruments can lead to unintended mistakes.

Who Should Trade Derivative Instruments?

The following groups can benefit from trading derivatives:

Commodity producers and miners )oil, gold, bitcoin, etc.$1683 can use futures or swaps to lock in selling prices for their products, thus hedging against price volatility.

Hedging funds and trading companies can leverage derivatives to protect their investment portfolios or implement advanced asset management strategies.

Individual traders and investors use derivatives to speculate on the price of specific assets. They can leverage to increase potential profits, though this also raises risks.

Conclusion

Derivative securities have become an integral part of modern financial markets. They provide powerful tools for risk management, speculation, and portfolio optimization. However, with great power comes significant risk. Before entering the world of derivatives trading, investors must understand how these instruments work, know how to manage risks, and only use capital they can afford to lose. With proper preparation and disciplined trading, derivatives can be an effective tool to create profit opportunities in the financial markets.