What is a derivative? A comprehensive guide to trading modern financial instruments [Real-life example]

When it comes to the financial market, many new investors are still unfamiliar with derivatives - a powerful tool but also carrying risks. If you want to understand this field better, the following article will help you grasp everything from basic definitions to how to profit from these transactions.

Definition: What exactly are derivatives?

Derivative securities (derivatives) are financial instruments whose value depends entirely on the fluctuations of the underlying asset. Instead of directly trading commodities or stocks, you are betting on their price changes.

The underlying assets can include:

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

When the prices of these assets fluctuate, the value of the corresponding derivative instruments also change. This makes pricing derivatives much more complex than regular financial tools.

History: From ancient times to the present

It is not a recent invention. The first futures contracts appeared in Mesopotamia as early as the 2nd millennium BC. However, these tools only truly developed in the 1970s with the advent of modern pricing techniques. Today, it’s hard to imagine a global financial system without derivatives.

Types: The 4 main categories of derivatives

The derivatives market is very diverse. Here is a detailed comparison of the four main types:

Trading channels: Your choice

There are 2 main ways to access the derivatives market:

1. OTC Market (Over-the-counter)

These are contracts made privately between two parties, completely outside regulatory oversight.

Advantages: Lower costs due to no intermediaries

Disadvantages: Higher risk - if the counterparty fails to fulfill the contract, you may have no protection

2. Regulated exchanges

Contracts must be thoroughly vetted before being listed. Each transaction is closely monitored.

Advantages: Protects the interests of both parties

Disadvantages: Higher transaction fees, less flexibility

The 2 most popular derivative tools

CFD (Contract for Difference)

CFD is an agreement between a trader and a broker to pay the difference in the price of an asset between the opening and closing of a position.

Features of CFD:

• No expiration date - you can hold the position as long as you want
• Can trade over 3000 different assets
• High leverage means very low initial capital
• Relatively low trading costs
• CFD prices closely track the underlying asset prices

###Option(

This tool grants you the right )not obligation( to buy or sell an asset at a specified price within a certain period.

Features of options:

• Contracts have a clear expiration date
• Positions can only be closed before or exactly on the expiration date
• Large trading volume, higher fees than CFDs
• Not all assets have options )due to regulatory requirements(
• Requires complex valuation formulas to determine price

Comparison: With CFDs, a 1-point move in the underlying asset does not necessarily equal a 1-point move in the CFD price. But with options, price movements depend on many factors.

Steps to execute a derivative trade

) Step 1: Choose and prepare

Select a reputable exchange with clear oversight. A good platform will protect you from counterparty risks.

Step 2: Deposit initial capital

The amount you need depends on:

• The quantity of assets you want to trade
• The leverage you use
• The policies of the trading platform

Step 3: Place a trade order

Based on your analysis:

• Predict price increase → Place a Long ###buy( order
• Predict price decrease → Place a Short )sell( order

You can place orders via mobile app or web version

) Step 4: Manage your position

Monitor the market, take profit when targets are reached, cut losses if the market moves against your prediction.

Real-world example: Making money from derivatives

Imagine you notice gold prices are at a peak, but you predict it will drop sharply as the economic situation stabilizes. You do not own physical gold but want to profit from this decline.

Solution: Use gold CFD to trade.

Open a Short position:

You open a Short ###sell( position at the current price of $1683/oz. When gold prices fall as predicted, you close the position by buying back at a lower price, say $1660/oz.

Profit = )- $1683 = $1660 per ounce

Using 1:30 leverage:

Instead of needing $23 to control 1 oz of gold, with 1:30 leverage, you only need to put in $56.1.

As you can see, leverage can amplify profits, but it also increases risks accordingly.

Why trade derivatives?

The derivatives market is not arbitrarily unpopular. It plays an important role in modern finance:

Hedging )Hedging(

If you own an asset with volatile prices, you can buy a derivative with an opposite price movement to offset losses.

Asset valuation

Futures prices help determine the fair value of the underlying asset in the market.

Market efficiency

When everyone can replicate the payoff of an asset via derivatives, the prices of the real asset and derivatives tend to balance, avoiding irrational price discrepancies.

Access to intangible assets

Through interest rate swaps, for example, a company can enjoy better interest rates than direct borrowing.

Risks you need to know

Like all financial tools, derivatives also have dark sides:

Extreme price volatility

Due to complex design, derivative prices are very hard to predict. Small changes in the underlying can cause huge swings in derivatives.

Speculative nature

High risks mean derivatives are often used for speculation rather than hedging. Wrong guesses can lead to devastating losses.

Counterparty risk )if OTC trading(

If you choose to trade on a decentralized market, there is a risk that the other party may not fulfill the contract.

Limited options

Not all assets have derivatives. Regulated contracts must pass strict vetting processes.

Who should trade derivatives?

Not everyone should participate, but these groups can benefit:

Commodity producers

Oil, gold, Bitcoin miners… can use futures or swaps to lock in prices, protect profits from sudden price swings.

Hedge funds and trading companies

They use derivatives to leverage, hedge portfolios, or enhance risk management.

Individual traders and investors

If you trust your analysis and are willing to accept high risks, derivatives can multiply profits - but also losses.

Final advice: Before entering the world of derivatives, make sure you understand each tool thoroughly, calculate your risk tolerance carefully, and only trade on reputable, well-regulated platforms.