What is the derivatives stock market? A comprehensive guide from definition to profit strategies

Looking Back at History: Derivative Instruments from Ancient to Modern Times

Derivatives are not a new invention. Since the time of Mesopotamia over 2000 years ago, humans have used similar contracts to manage risks in trade. However, the true development of the modern derivatives market began in the 1970s, when economists developed new pricing methods. Since then, these tools have become an indispensable part of the global financial system.

What is a (derivative) Security?

A derivative security is a financial instrument whose value is based on the fluctuations of an underlying asset. This underlying asset can be many different types:

• Commodities: crude oil, gold, silver, agricultural products
• Financial assets: stocks, bonds
• Indices and interest rates: stock indices, bank interest rates

When the price of the underlying asset changes, the value of the derivative security also fluctuates accordingly. This characteristic makes derivative pricing more complex than traditional financial instruments.

The Four Main Types of Derivative Contracts

In the market, there are many different derivative instruments, each serving specific purposes:

1. Forward Contract (Forward)

• An agreement between two parties to buy or sell an asset at a fixed price in the future
• No third-party intervention, low transaction costs
• Risk: one party may fail to fulfill the contract at maturity

2. Futures Contract (Future)

• A standardized version of a forward contract, listed on an official exchange
• Higher liquidity, daily price updates
• Both parties must post margin to ensure settlement

3. Options Contract (Option)

• Grants the owner the right (not the obligation) to buy or sell an asset at a specified price within a certain period
• This right has a tradable value
• Used for speculation or hedging risks

4. Swap Contract (Swap)

• Two parties exchange cash flows based on agreed terms
• Usually traded over-the-counter (OTC)
• Parties negotiate specific terms, no standardization

Two Channels for Trading Derivative Securities

Decentralized OTC Market (OTC - Over-The-Counter)

• Contracts are executed directly between two parties without intermediaries
• Lower costs due to absence of third parties
• Disadvantage: higher risk of counterparty default

Regulated Exchanges

• Contracts must be approved before listing
• Higher transaction fees but with legal protections
• Greater transparency and safety

CFDs and Options: The Two Most Popular Derivative Tools

Contract For Difference (CFD)

• Both parties agree to settle the difference in price when opening and closing the position
• Can trade over 3000 assets
• High leverage, low initial investment
• Very low trading costs
• No expiration date, positions can be closed at any time
• Price closely tracks the underlying asset

Options (Options)

• Larger trading size, higher trading fees
• Have a fixed expiration date, can only be closed before or on the expiration date
• Not all assets have options contracts because they require regulation
• Prices are calculated using complex valuation formulas

Derivative Trading Process

Step 1: Choose and Open an Account Selecting a reputable trading platform is the first step. A trustworthy exchange helps you avoid the risk of counterparty default.

Step 2: Deposit Margin The margin amount depends on the asset type, quantity, and leverage you wish to use.

Step 3: Place a Trade Order Based on your market forecast, place a Long (predict rise) or Short (predict fall) order through the trading platform.

Step 4: Manage Your Position Monitor the market, take profit when reaching your target profit, or cut losses to control risk.

Real-Life Example: Profiting from Gold Price Fluctuations

Suppose gold is currently at a peak of $1683/oz. Based on economic analysis, you forecast a sharp decline in gold prices soon. You decide to profit from this volatility without owning physical gold by trading a gold CFD.

Open a Short (sell) position You sell gold at $1683/oz with the hope of buying back at a lower price when the price drops.

Using 1:30 leverage Instead of needing $1683 to buy 1oz of gold, you only need $56.1 of initial capital:

• Scenario 1 - Price drops as forecasted: Gold drops to $1660, you close the position and make a $23 profit$17 . With 1:30 leverage, this is a 41% gain on your initial capital. Without leverage, only 1.36% profit.

• Scenario 2 - Price rises against forecast: Gold rises to $1700, you cut losses at a (loss). With leverage, you lose 30% of your capital. Without leverage, only 1% loss.

This example clearly illustrates how leverage can amplify both profits and losses.

Benefits of the Derivatives Market

Hedging Risks Oil producers can use futures contracts to lock in prices, avoiding adverse price movements. Profits from derivatives offset losses from the underlying assets.

Price Discovery The spot price of futures contracts reflects the true market value of commodities.

Market Efficiency Derivatives allow replication of asset payoffs. When arbitrage opportunities arise, traders exploit them, exerting pressure that pushes the prices of the underlying and derivative assets toward equilibrium.

Better Access to Interest Rates Through interest rate swaps, companies can achieve more favorable borrowing rates than direct loans.

Risks to Know About Derivatives

High Volatility and Large Losses The complex design of derivatives makes valuation extremely difficult. High risk is inherent in these instruments.

Speculative Nature Derivative prices are unpredictable due to high volatility. Hasty speculative decisions can lead to significant losses.

OTC Counterparty Risk OTC Over-the-counter contracts carry the risk that the counterparty may default.

Who Should Trade Derivatives?

Commodity Producers Oil, gold, Bitcoin producers can lock in prices for their products via futures or swaps, reducing the impact of price volatility.

Hedge Funds and Trading Firms Use derivatives to leverage, hedge portfolios, or enhance risk management.

Individual Traders and Investors Use derivatives to speculate on price movements, potentially leveraging to amplify profits.

The derivatives market plays a vital role in modern finance, but success requires deep understanding and careful risk management.