What is derivatives? A detailed guide to trading derivatives securities and making profits [With real-life examples]

This article provides a comprehensive guide on: what derivatives are, the common types of derivative securities, trading mechanisms, and real-world examples to help you better understand this market.

What are derivatives? Basic concepts

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

When the price of the underlying asset changes, the value of the derivative instrument also changes accordingly. Therefore, pricing derivatives is much more complex than regular financial tools.

Although the term “derivatives” may sound familiar today, these instruments have existed for a long time. As early as the second century BC in Mesopotamia, primitive futures contracts appeared. However, derivatives truly developed from the 1970s when mathematical pricing models were created, and today, derivatives markets have become an indispensable part of the global financial system.

Main types of derivative securities

There are 4 widely used derivative instruments:

1. Forward Contract (Forward)

An agreement between two parties to buy/sell an asset at a predetermined price, settled at expiration. This contract type is flexible but carries risk from the counterparty.

2. Futures Contract (Futures)

A standardized version of the forward, traded on an official exchange. Prices are adjusted daily based on market movements, and parties must post margin to ensure settlement.

3. Options (Options)

A tool that grants the right (not obligation) for the buyer to buy or sell an asset at a specified price within a certain period. Options have intrinsic value and can be traded independently.

4. Swaps (Swaps)

Exchange of future cash flows between two parties based on certain principles. These contracts are usually traded OTC and cannot be freely bought or sold like other certificates.

Two forms of derivatives trading

1. OTC Trading (Over-the-Counter)

OTC derivatives are privately negotiated between two parties without regulatory oversight. The advantage is lower costs due to no intermediaries, but the risk is higher due to lack of third-party guarantees.

2. Exchange-Traded

Derivatives listed on official exchanges must go through a prior approval process. Although transaction costs are higher, the rights of the parties are strongly protected.

Popular derivative tools: CFDs and Options

CFD (Contract for Difference): An agreement between an investor and a broker to exchange the difference in the price of an asset between opening and closing positions. This is a popular and reliable OTC instrument today. CFDs have no expiration date, can be closed at any time, apply to over 3000 different commodities, use high leverage resulting in low capital requirements, and have low transaction costs.

Options: Grant (non-mandatory) rights to traders to buy or sell an asset at a certain price within a specified timeframe. This is the most modern tool among listed derivatives. Options have a fixed expiration date, can only be closed before or on the expiration date, are selectively applied to regulated commodities, and have higher transaction fees than CFDs.

Steps to trade derivatives

Step 1: Open an account

Choose a reputable trading platform or broker to open a derivatives trading account. This helps you avoid risks of the counterparty not fulfilling the contract.

Step 2: Deposit margin

Deposit funds into your account according to the amount of assets you want to trade and the leverage you plan to use.

Step 3: Place trading orders

Once you have sufficient margin, you can place Long (predict price increase) or Short (predict price decrease) orders via the trading platform.

Step 4: Manage positions

Monitor your positions, set profit targets and stop-loss levels to control risks.

Real-world example: Profit from gold price fluctuations

Suppose the current gold price is high ($1683/oz), and based on your analysis, you predict a sharp decline as the economic situation stabilizes. You want to profit from this trend but do not own physical gold, so you use a derivative instrument based on gold (CFD gold).

Create a Short position

Since you expect the price to fall, you open a Short position, meaning you sell gold at $1683/oz. When the price drops as predicted, you close the position by buying back at a lower price.

Use 1:30 leverage

To reduce initial capital, you use 1:30 leverage, decreasing the required capital by 30 times. Leverage amplifies profit percentages but also increases risk proportionally.

Compare results:

Scenario 1: Using 1:30 leverage

• Initial capital needed: $56.1 (instead of $1683)
• If the price drops to $1660: Profit $23 = 41% profit
• If the price rises to $1700: Loss $17 = 30% loss

Scenario 2: No leverage

• Initial capital needed: $1683
• If the price drops to $1660: Profit $23 = 1.36% profit
• If the price rises to $1700: Loss $17 = 1% loss

This example shows that leverage can magnify both gains and losses.

Benefits of trading derivatives

Risk hedging

The original purpose of derivatives is to help traders hedge against price volatility. By buying assets with opposite price movements, investors can offset losses from the underlying asset.

Asset valuation

The spot price of futures contracts can serve as an approximate fair value of commodities, helping to balance the market.

Market efficiency

Using derivatives to replicate cash flows of assets can create arbitrage opportunities, thus keeping the prices of the underlying and derivative assets in equilibrium.

Access to intangible assets

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

Risks of trading derivatives

High volatility

Derivatives are highly volatile and can cause significant losses. The complex design of contracts makes valuation extremely difficult, sometimes even impossible.

High speculative risk

Due to their extremely risky nature and large price swings, derivative prices are unpredictable. Speculative trading without proper risk management can lead to substantial losses.

OTC contract risks

OTC contracts are unregulated; if the counterparty fails to fulfill the contract at maturity, you could lose all your investment.

Who should trade derivatives?

Commodity companies

Oil, gold, or other commodity producers can use futures or swaps to lock in selling prices, thus hedging against price fluctuations.

Hedge funds and trading firms

These organizations use derivatives to leverage, build hedges against risks, or enhance portfolio management.

Individual traders and investors

They use derivatives to speculate on price movements and can leverage to increase potential profits.

Conclusion

What derivatives are and why they are important are questions every investor should understand. Derivatives are powerful tools but also carry significant risks, requiring traders to have solid knowledge, clear risk management plans, and disciplined trading to succeed.