What is Derivative Trading? Making Money from the Derivatives Stock Market - Detailed Guide

Derivatives - Modern Financial Instruments

When talking about what are derivatives, this is a financial tool whose value depends entirely on the fluctuations of an underlying asset. This underlying asset could be physical commodities (such as crude oil, gold, silver, agricultural products), or financial assets (such as stocks, bonds, stock indices, interest rates).

The history of this instrument is quite long. Since Mesopotamian times before Christ, futures contracts have appeared. However, the true development of the derivatives market began in the 1970s when advanced pricing methods were invented. Today, no modern financial system can exist without the presence of this tool.

When the underlying asset’s price changes, the corresponding derivatives also fluctuate. Therefore, pricing derivatives is more complex than traditional financial assets.

The Path of Derivative Trading: Two Main Options

Investors have two main channels to conduct transactions:

Centralized OTC Market (: These are contracts executed directly between two parties without regulatory oversight. Costs are lower due to no intermediaries, but the risk is relatively high — the other party may not fulfill the contract at maturity.

Regulated Market: Derivatives here must undergo strict vetting before being listed. Although costs are higher, the rights of the parties are fully protected.

Common Types of Derivative Contracts

) Forward Contract ###

This is an agreement to buy or sell the underlying asset at a predetermined price, executed at the expiration date. Features:

• Payments are made according to an agreed schedule
• No intermediaries involved
• No fees incurred by the parties

( Futures Contract )Future###

A standardized version of the forward contract, traded on official stock exchanges:

• More liquid than forward contracts
• Both parties must deposit margin at the exchange
• Prices are revalued daily according to the market

( Options )Option###

This tool grants (the right but not the obligation) for the holder to buy or sell the underlying asset at a set price within a certain period:

• The only financial instrument that provides the right, not the obligation
• Option prices are based on the current market price of the underlying asset
• Widely traded on official exchanges

( Swap )Swap###

A transaction between two parties involving the exchange of cash flows, based on mutually agreed principles:

• Usually traded outside official markets
• Customized contracts tailored to needs
• Cannot be bought or sold like regular securities

The Most Popular Instruments

( CFD - Contract for Difference

CFD is an agreement to pay the difference in the asset’s price between the opening and closing of the position. It is the most common instrument on OTC markets because it is a direct contract between the investor and the broker.

Features of CFD:

• No expiration date, can be closed at any time
• Applicable to over 3000 different assets
• Allows high leverage, requiring low initial capital
• Very low transaction costs compared to options

) Options

This tool grants traders the right to buy or sell at a specified price within a certain timeframe, without obligation to do so.

Features of Options:

• Contracts have a fixed term and can only be closed before or on the expiration date
• Only regulated assets have options contracts
• Large trading volume, higher fees
• Prices must be calculated using complex valuation formulas

Comparison: Like options, CFDs also allow traders to speculate on market trends. However, CFDs prices are always close to the underlying asset, whereas a small movement in the underlying may not correspond exactly to a point change in the contract.

How to Start Derivative Trading

Step 1: Choose and Open an Account

Selecting a reputable trading platform is the first crucial step. A reputable platform helps you avoid the risk of the counterparty not fulfilling the contract. Check licensing and reputation before registering.

Step 2: Deposit Margin

Depending on the number of assets you want to trade and the leverage used, you need to deposit the corresponding margin into your account. This amount acts as a guarantee of contract performance.

Step 3: Place Orders and Execute Trades

After sufficient margin is deposited, you can place buy ###Long### or sell (Short) orders based on your market trend predictions. Orders can be placed via mobile app or web version.

( Step 4: Manage Positions and Exit Orders

Continuously monitor your positions, identify take-profit and stop-loss points to protect capital. This is a key factor in the success or failure of a trader.

Real-Life Example: Making Money from Gold Price Fluctuations

Suppose gold is currently at $1683/oz, and based on your experience and analysis, you forecast a sharp decline as the economic situation stabilizes. Although you do not own physical gold, you can leverage CFD tools based on gold prices.

Create a Short Position: Since you expect the price to fall, open a Short )sell### position at $1683/oz. When the gold price drops as forecasted, close the position (buy back) at a lower level, say $1660/oz.

Use Leverage: With 1:30 leverage, the initial capital to trade 1 oz of gold is only $56.1 instead of $1683. This maximizes profit:

• If the price drops to $1660, you gain (= 41% profit )with leverage$23
• Without leverage, profit is only 1.36%

However, leverage also amplifies losses:

• If the price rises to $1700, you lose (= 30% of your capital )with leverage$17
• Without leverage, only 1% loss

Benefits of the Derivatives Market

It is no coincidence that these tools are widely traded across most global financial markets:

Risk Hedging: Originally designed to protect parties from price volatility. Investors can buy an asset whose price moves opposite to their owned asset, offsetting losses.

Asset Pricing: The spot price of futures contracts can reflect the market value of commodities, helping to determine fair prices.

Market Efficiency: By using derivatives to replicate the payout of assets, the prices of the underlying and derivative tend to stay balanced, limiting arbitrage opportunities.

Access to Intangible Assets: Through interest rate swaps, companies can achieve more favorable interest rates compared to direct borrowing.

Hidden Risks

Like any financial product, trading derivatives involves significant risks:

Extreme Price Volatility: The sophisticated design of contracts makes derivatives pricing extremely complex, sometimes unpredictable. High risk is inherent to these tools.

Speculative Nature: Due to high risk and volatility, derivative prices are difficult to forecast accurately. Reckless speculative decisions can lead to substantial losses.

Counterparty Risk: If trading OTC, you must accept the risk that the counterparty may not fulfill the contract at maturity. Officially listed exchanges mitigate this risk.

Who Should Trade Derivatives

This instrument serves various groups:

Commodity Exploitation Companies: Oil, gold, or other commodity producers can use futures contracts to lock in prices and hedge against volatility.

Hedging Funds and Trading Firms: They utilize derivatives to leverage positions or hedge risks, enhancing portfolio management.

Individual Traders and Investors: They use derivatives to speculate on asset trends, often employing leverage to increase potential profits.

Understanding what derivatives are and how they operate is a prerequisite to becoming a skilled trader, helping you make cautious decisions and manage risks effectively.