What Are Derivative Stocks? A Guide to Trading and Profiting from the Derivative Market

In this article, we will explore important aspects of derivative stocks (derivatives): definitions, how they work, main types, and effective trading strategies.

What Are Derivative Stocks?

Derivative stocks (or also called derivative securities) are financial instruments whose value depends entirely on the price movements of the underlying asset (underlying asset). This asset can be commodities such as crude oil, gold, silver, agricultural products, or financial assets like stocks, bonds, market indices, interest rates, and even cryptocurrencies.

Although derivative stocks are not a new concept—futures contracts have existed since ancient Mesopotamia—they only gained significant development from the 1970s when modern pricing techniques emerged. Today, derivative stocks have become an integral part of the global financial system.

When the price of the underlying asset changes, the price of the derivative stock will also fluctuate accordingly. This makes valuing these instruments much more complex than traditional financial tools.

Main Types of Derivative Stocks

The derivatives market is very diverse with many different instruments. Here are the four most common types of derivative stocks:

Forward Contract (Forward)

This is an agreement between two parties to buy or sell a specific amount of the underlying asset at a predetermined price, to be executed at a future date. Payment occurs at the agreed time. This contract involves no intermediary organization, and the parties do not pay administrative fees.

Futures Contract (Futures)

A standardized, publicly listed, and exchange-traded contract. Futures are more liquid than forward contracts. Both parties must deposit margin at the exchange to ensure settlement. The contract’s value is marked-to-market daily based on current market prices.

Options Contract (Options)

A unique derivative instrument that gives the holder the right (not the obligation) to buy or sell an asset at a specified price within a certain period. Because options have intrinsic value, they possess their own market price. The value of an options contract is determined based on the underlying asset’s price.

Swap Contract (Swap)

An agreement between two parties to exchange two cash flows calculated based on specified principles. Swaps are typically traded over-the-counter (OTC) and are private agreements between the involved parties.

Two Methods of Trading Derivative Stocks

1. OTC Trading (Over-the-Counter)

OTC derivative contracts are privately negotiated between two parties and are not tightly regulated. The advantage of OTC is lower costs due to the absence of third-party involvement. The downside is the risk that one party may default on the contract at maturity.

2. Trading on Regulated Exchanges

Derivative stocks listed on these exchanges must undergo prior approval processes. Although transaction fees are higher, the rights and obligations of the parties are protected and enforced by law.

Comparing CFD and Options - The Two Most Popular Instruments

CFD (Contract for Difference)

A CFD is an agreement between two parties to settle the difference in the price of an asset from the opening to the closing of a position. It is the most common instrument on OTC platforms because it is a direct contract between the investor and the liquidity provider.

Features of CFDs:

• No expiration date; positions can be closed at any time
• Applicable to over 3000 assets
• High leverage, low initial capital
• Much lower transaction costs than options
• CFD prices closely track the underlying asset’s price

Options (Options)

Options give traders the right (but not the obligation) to buy or sell an asset at a certain price within a specific period. It is the most modern instrument among derivatives traded on official exchanges.

Features of options:

• Contracts have a defined expiration date; positions can only be closed before or on the expiration date
• Not all assets have options due to regulation
• Large trading volume and higher transaction fees
• Option prices must be calculated using complex valuation formulas
• Moving one point in the underlying asset does not always equate to one point in the option’s price

Step-by-Step Process for Trading Derivative Stocks

Step 1: Choose a Reputable Trading Platform

The first step is selecting a trustworthy trading platform. A reputable platform helps you avoid risks from parties not fulfilling their contractual obligations. Check if the platform is licensed by financial regulatory authorities.

Step 2: Prepare Initial Capital

Determine the margin amount needed based on the volume of assets you want to trade and the leverage you plan to use. Only deposit an amount you can afford to lose.

Step 3: Execute the Trade

After depositing funds, you can place trading orders. Based on your market prediction, place a Long (if you expect prices to rise) or Short (if you expect prices to fall). You can use mobile apps or web versions.

Step 4: Manage Your Positions

Continuously monitor your positions. Set profit targets and maximum loss limits before entering the trade. Close positions promptly to protect profits or limit losses.

Practical Example: Profiting from Gold Price Volatility

Let’s consider a specific scenario. You observe that gold is currently at a high of $1683/oz. Based on experience and analysis, you predict that after economic stabilization, gold prices will drop sharply. You want to profit from this forecast but do not own physical gold, so you use a gold CFD to trade.

Open a Short Position

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

Use Leverage

Gold at $1683/oz is too high relative to your current capital. To reduce the initial capital requirement, you decide to use 1:30 leverage. This means you only need $56.1 in actual capital instead of $1683.

Compare Results:

Scenario 1: Using 1:30 leverage

• Initial capital: $56.1
• Gold price drops to $1660 (profit): 41% profit
• Gold price rises: $23 $1700 loss(: 30% loss

Scenario 2: No leverage

• Initial capital: )- Gold drops to $1660: 1.36% profit
• Gold rises to $1700: 1% loss

As you can see, leverage can significantly increase profits but also proportionally increase risks.

Benefits of Derivative Stock Trading

Derivative stocks are widely traded worldwide for valid reasons:

**Hedging $17 Risk Management$1683 **

Originally created to help investors protect against price volatility. You can buy a derivative that moves inversely to your main asset to offset losses.

Asset Pricing

The price of futures contracts can reflect market expectations of future commodity prices, aiding in fair valuation.

Market Efficiency

Through derivatives, participants can replicate the returns of various assets. This tends to balance the prices of underlying assets and derivatives, preventing arbitrage opportunities.

Access to Intangible Assets

Via instruments like interest rate swaps, a company can obtain more favorable interest rates than through direct borrowing.

Risks to Be Aware Of

Like any financial product, trading derivative stocks involves certain risks:

High Price Volatility

The complex structure of these contracts makes valuation extremely difficult, sometimes impossible. High price volatility is inherent in derivative stocks.

Market Speculation Risks

Due to high risk and volatility, prices of derivatives are hard to predict. Unreasonable speculation can lead to significant losses.

Counterparty Risk

Especially with OTC contracts, there is a risk that the other party may default on the agreement.

Deep Knowledge Requirement

Valuation and position management require in-depth knowledge and experience.

Who Should Trade Derivative Stocks?

Several groups can benefit from derivative stocks:

Commodity Exploitation Companies

Oil, gold, or Bitcoin mining companies can use futures contracts to lock in prices, thus hedging against unwanted price fluctuations.

Investment Funds and Trading Companies

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

Individual Traders and Investors

These individuals use derivatives to speculate on market movements and may leverage to increase potential returns.

Conclusion

Derivative stocks are powerful financial tools with high profit potential but also significant risks. Before trading, ensure you understand how they operate, the different types of instruments, and the associated risks. Start small, manage risks carefully, and never trade with money you cannot afford to lose.