What is Derivatives? A Guide to Trading and Earning Money from Modern Financial Instruments

History and Role of Derivatives in Modern Finance

Derivatives are not a new concept. Since the time of Mesopotamia over 4000 years ago, humans have used futures contracts to hedge risks in commodity trading. However, they only became widely popular in the 1970s, when modern valuation techniques emerged, marking the explosion of the global derivatives market.

Today, no modern finance system exists without derivatives. They play a crucial role in risk management, increasing liquidity, and creating profit opportunities for investors.

What Are Derivatives? Definition and Nature

Derivative securities (derivatives) are financial instruments whose value depends on the price of an underlying asset, called the underlying asset. This asset can be commodities (crude oil, gold, silver, agricultural products), financial assets (stocks, bonds), or even indices (stock indices, interest rates, exchange rates).

When the price of the underlying asset changes, the value of the derivative also fluctuates accordingly. This is also why pricing derivatives is more complex than traditional financial instruments — because their prices are influenced by many different variables.

Main Types of Derivatives in the Market

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

Two Main Forms of Derivative Trading

OTC Trading (Over-The-Counter) - Over-the-Counter Market

OTC derivatives are customized contracts between two parties without third-party oversight. The advantage is lower transaction costs, but the risk is higher because the counterparty may not fulfill the contract on time.

Exchange-Traded - Centralized Market

Derivatives on official exchanges must undergo verification processes before trading is permitted. Although transaction fees are higher, investors are assured of legal rights and obligations.

The Most Popular Derivative Instruments

1. CFD (Contract for Difference)

CFD is an agreement between two parties to pay the difference in the price of an asset from the time the position is opened until it is closed. It is the most widely used instrument on OTC platforms because it is a direct contract between the investor and the broker.

Features of CFDs:

• No expiration date, can be closed at any time
• Applicable to over 3000 assets
• High leverage, low capital investment
• Very low trading costs
• CFD prices closely follow the underlying asset prices at that moment

2. Options (Options)

Options give the right (but not obligation) to buy or sell an asset at a specified price within a certain timeframe. This is the most modern instrument on official trading platforms.

Features of Options:

• Contract with a fixed term, can only be closed before or on the expiration date
• Only assets regulated by the government are eligible for options
• Large trading volume, significant costs
• Require complex pricing formulas

Step-by-Step Guide to Trading Derivatives

Step 1: Open a Trading Account

Choosing a reputable trading platform is the first step. A trustworthy exchange will help you avoid risks from counterparties not fulfilling contracts.

Step 2: Deposit Initial Margin

The margin amount depends on the quantity of commodities you want to trade and the leverage used. The higher the leverage, the less initial capital you need.

Step 3: Execute Buy/Sell Trades

After depositing margin, you place a Long (predict price increase) or Short (predict price decrease) order via mobile app or web version.

Step 4: Manage Positions - Take Profit and Stop Loss

Monitor your positions, take profit when your prediction is correct, or cut losses if the market moves against you.

Real-Life Example: Making Money from Gold Price Fluctuations

Suppose the current gold price is $1683/oz and you predict that after economic stabilization, gold prices will drop sharply. You do not own physical gold but want to profit from this decline using a gold CFD.

Open a Short Position

Since you expect the price to fall, you open a Short position — selling gold at the current $1683/oz. When the price indeed drops as predicted, you buy back (close the position) at a lower price, earning the difference.

Use 1:30 Leverage

Because the gold price is very high relative to your current capital, you use 1:30 leverage to reduce the initial capital outlay by 30 times. This increases potential profit but also amplifies risk accordingly.

Profit Comparison With and Without Leverage:

This example clearly shows: using leverage wisely can multiply profits, but risks are also proportionally increased.

Why Trade Derivatives?

( 1. Risk Hedging )Hedging###

The original purpose of derivatives was to hedge risks. Investors can buy an asset that moves inversely to their owned asset, offsetting losses when the market is unfavorable.

( 2. Underlying Asset Pricing

The spot price of futures contracts can serve as an approximation of the commodity’s price, aiding in more accurate valuation of the underlying asset.

) 3. Improving Market Efficiency

By using derivatives, one can replicate the payout profile of an asset. The prices of the underlying and related derivatives tend to stay in balance, avoiding unreasonable price discrepancies.

4. Increasing Access to Intangible Assets

Through interest rate swaps, a company can obtain more favorable interest rates compared to direct borrowing.

Inherent Risks of Derivatives

High Volatility and Large Losses

The complex design of derivatives makes valuation extremely difficult or even impossible. High risk is an inherent feature of these instruments.

Fundamental Unpredictability

Derivative prices are inherently unpredictable; irrational speculation can lead to significant losses.

OTC Market Risks

Trading on decentralized platforms carries the risk that the counterparty may not fulfill the contract as agreed.

Need for Deep Knowledge

Investors must understand the mechanisms, pricing methods, and risk management strategies to avoid losses.

Who Should Trade Derivatives?

Commodity Companies

Oil, gold, Bitcoin, or other commodity producers can use futures or swaps to lock in selling prices and hedge against adverse price fluctuations.

Investment Funds and Trading Companies

Hedge funds and trading firms use derivatives to leverage, protect portfolios, or enhance risk management.

Traders and Individual Investors

These individuals use derivatives to speculate on assets they trust and may leverage to increase profits, but must have solid risk management knowledge.

Conclusion

Derivatives are powerful financial tools but also carry significant risks. To succeed, investors should:

• Fully understand how each derivative works
• Have strict risk management plans
• Choose reputable trading platforms
• Start with small capital to gain experience
• Never invest money they cannot afford to lose