What are derivatives? A comprehensive guide to trading derivative instruments and how to profit

What Are Derivatives - The Foundation of Modern Financial Markets

Derivative (derivative) is a valuable financial instrument whose value is determined based on the price of an underlying asset. Unlike direct ownership certificates, derivatives allow investors to participate in price fluctuations without owning the asset.

The underlying assets of derivatives can be:

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

Although derivatives are not a new concept (futures contracts have existed since the second century BCE in Mesopotamia), they only gained widespread development from the 1970s when modern pricing techniques emerged.

Risks and Opportunities in Derivative Trading

Before exploring different types of derivatives, investors need to understand the inherent risks of these instruments:

Main Risks:

• Price volatility can be very high, leading to rapid losses
• Derivative valuation is more complex than other financial tools
• Derivatives are often considered speculative tools, requiring skill and experience
• Prices change in unpredictable ways

However, when used appropriately, derivatives offer many opportunities:

• Hedging: protecting investment portfolios against price fluctuations
• Market efficiency: balancing prices between the spot market and derivatives
• Access to hard-to-reach assets: instruments like interest rate swaps provide better financial conditions
• Profit from both directions: potential gains in rising and falling markets

Main Types of Derivative Instruments

The derivatives market consists of four basic contract types, each with its own characteristics:

1. Forward Contracts (Forward)

This is a private agreement between two parties to buy or sell an asset at a predetermined price at a future date. These contracts are traded over-the-counter (OTC) (OTC).

Features:

• Settlement occurs at the expiration date
• No centralized oversight organization
• No official transaction fees
• Risk: the counterparty may fail to fulfill the contract

2. Futures Contracts (Futures)

Similar to forward contracts but standardized and listed on official exchanges, thus under stricter regulation.

Features:

• Prices are updated daily based on market movements
• Parties must post margin at the exchange to ensure settlement
• Higher liquidity than forward contracts
• Lower counterparty risk due to exchange oversight

3. Options (Options)

This tool gives investors the right but not the obligation to buy (call) or sell (put) an asset at a specified price within a certain timeframe.

Features:

• Options have intrinsic value and are traded as assets
• Buyers have the choice, not the obligation
• Prices are determined through complex valuation formulas
• Usually traded on centralized exchanges

4. Swaps (Swaps)

Contracts between two parties to exchange cash flows based on predefined principles.

Features:

• Traded outside centralized exchanges
• Specific private agreements between two parties
• Cannot be freely exchanged like other exchange-traded instruments

Two Main Ways to Trade Derivatives

OTC Trading (Over-the-counter)

OTC derivatives are contracts made privately between two parties without formal regulation.

Advantages: Lower transaction costs due to lack of intermediaries
Disadvantages: Counterparty risk of non-performance

Exchange-Traded Trading (Regulated by the State)

Listed derivatives undergo prior approval.

Advantages: Parties are protected, ensuring settlement
Disadvantages: Higher transaction fees, limited product range

CFD and Options - The Two Most Popular Tools

In practice, the two most widely used tools are CFD (Contract for Difference) and Options.

CFD (Contract for Difference): An agreement to pay the difference in the asset’s price between opening and closing the position. This is the most common OTC instrument because it is a contract between the investor and the provider.

Options: Allow traders the right (but not the obligation) to buy or sell an asset at a predetermined price within a specified timeframe. This is the most modern tool listed on exchanges.

Comparison of CFD and Options:

How to Start Trading Derivatives

To participate in the derivatives market, investors should follow these steps:

Step 1: Choose a reputable trading platform

Selecting a reliable platform is crucial to avoid risks. Look for platforms regulated by financial authorities.

Step 2: Open a trading account

Complete identity verification and set up your trading account.

Step 3: Deposit initial capital

Fund your account with margin. The amount depends on:

• The number of assets you wish to trade
• The leverage you use
• The expected position size

Step 4: Execute trades

Place buy (Long) or sell (Short) orders based on your market forecast. You can use mobile apps or web versions.

Step 5: Manage your positions

Monitor open positions, identify take-profit and stop-loss points appropriately.

Real-World Example: Trading Gold with CFD

Suppose you predict gold prices will fall after economic stabilization, even though you do not own physical gold. You decide to trade CFD gold to profit from this forecast.

Open a Short Position:

You open a sell position at the current price of $1683/oz. When gold prices decline as predicted, you close the position by buying back at a lower price (e.g., $1660/oz).

Using 1:30 Leverage:

Since gold is expensive, you use 1:30 leverage to reduce the initial capital by 30 times:

• Capital needed for 1 oz of gold: $56.1 $1660 instead of $1683$23

Profit Scenario:

If gold drops as forecasted:

• With 1:30 leverage: Profit $23 = 41%
• Without leverage: Profit $1700 = 1.36%

Loss Scenario:

If gold rises against your forecast:

• With 1:30 leverage: Loss (= -30% of capital
• Without leverage: Loss )= -1% of capital

This example shows leverage can amplify both gains and risks.

Who Should Trade Derivatives?

Suitable groups for derivatives trading include:

Commodity producers $17 oil, gold, Bitcoin…$17 : They can lock in prices via futures or swaps to hedge against price volatility of their commodities.

Investment funds and trading companies: Use derivatives to optimize portfolios, hedge risks, or leverage.

Individual traders and investors: Use derivatives to speculate on price movements and increase profits through leverage.

The Importance of Derivatives in Modern Finance

Derivatives are not unfamiliar tools. They play a vital role in the global financial system:

• Risk management: Allow organizations and individuals to hedge their positions
• Efficient pricing: Derivative prices help determine fair value of underlying assets
• Market balancing: Facilitate equilibrium between different markets
• Flexible access: Open opportunities to better financial conditions

Understanding what derivatives are and how to trade them is the first step for investors to make informed decisions when entering this market. The goal is to use these tools wisely, manage risks effectively, and develop trading strategies aligned with their objectives and risk tolerance.