What is Derivatives Trading? A Guide to Trading and Real-Life Examples

Basic Concepts of Derivatives

Derivatives (are financial instruments whose value depends on the price of the underlying asset. Instead of owning the asset directly, investors trade based on price fluctuations. The underlying asset can be commodities )crude oil, gold, silver, wheat(, financial assets )stocks, bonds(, stock indices, or interest rates.

When the price of the underlying asset changes, the value of the derivative also fluctuates accordingly. This characteristic makes pricing derivatives more complex than traditional financial instruments.

Development History of the Derivatives Market

Although they appeared early )the first futures contracts recorded from ancient Mesopotamia(, derivatives only became widespread from the 1970s, when modern valuation techniques emerged. Today, we cannot imagine a modern financial system without the participation of the derivatives market.

The Four Main Types of Derivatives

Each derivative type has distinct features:

Forward Contract )Forward(

• An agreement between two parties to buy or sell the underlying asset at a predetermined price in the future
• No intermediary involved, no transaction fees
• Settlement occurs at the agreed-upon time in the contract

Futures Contract )Futures(

• Standardized contracts listed on exchanges
• More liquid than forward contracts
• Parties must post margin to ensure settlement capability
• Prices are updated daily based on market movements

Options )Options(

• Give the holder the right )but not the obligation( to buy or sell the asset at a specified price
• The only derivative instrument that allows the holder not to execute the transaction
• Price depends on the market value of the underlying asset
• Traded on regulated exchanges

Swaps )Swaps(

• Transactions between two parties to exchange cash flows
• Usually traded OTC (over-the-counter), not on centralized exchanges
• Cash flows are calculated based on specific principles

Two Methods of Trading Derivatives

1. OTC Trading )Decentralized Trading( Contracts are executed privately between two parties and are not controlled by an intermediary. Transaction costs are lower, but there is a risk that the counterparty may not fulfill the contract as agreed.

2. Exchange-Traded Derivatives Derivatives must undergo pre-listing approval. Although transaction fees are higher, the rights and obligations of the parties are protected.

CFD and Options: Two Popular Derivative Instruments

CFD )Contract for Difference(

• Settlement based on the difference in price between opening and closing positions
• No expiration date; positions can be closed at any time
• Applicable to over 3000 assets
• High leverage, low capital requirement
• Low transaction costs
• Prices closely track the underlying asset

Options

• Provide the right to buy or sell at a certain price within a specified period
• Contracts have a fixed term and can only be closed before or on the expiration date
• Not all assets have options contracts
• Large trading volume, higher fees
• Prices must be calculated using complex valuation formulas

Derivative Trading Process

Step 1: Choose a Reputable Exchange Selecting a reputable exchange is crucial to avoid risks from counterparties not fulfilling contracts. A good exchange will have licensing criteria, transparency, and regulatory recognition.

Step 2: Open a Trading Account Investors need to open a derivatives trading account with the chosen exchange. This process typically includes verifying personal information.

Step 3: Deposit Initial Capital The margin required depends on the number of assets to be traded and the leverage used. Higher leverage allows trading with less capital but increases risk.

Step 4: Place a Trading Order Based on market predictions, investors place a Long )predicting price increase( or Short )predicting price decrease( order. Orders can be executed via mobile app or web platform.

Step 5: Manage Positions After opening a position, investors must continuously monitor, determine appropriate take-profit points, and set stop-loss levels to control risks.

Real-Life Example: Gold Trading

Suppose gold is currently priced at $1683/oz, and the investor predicts a decline after economic stabilization. Instead of owning physical gold, the investor uses a gold CFD to capitalize on this price movement.

Open Short Position: Sell gold at $1683/oz, expecting the price to fall.

Using 1:30 Leverage:

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

Without leverage, with the same movement: Profit $17 = 1.36% or loss $23 = 1% of initial capital

This example shows how leverage can amplify both gains and losses.

Benefits of Derivative Trading

Hedging Risks The original purpose of derivatives was to hedge. Investors can buy assets that move inversely to their current holdings, offsetting losses.

Asset Price Discovery The spot prices of futures contracts can serve as approximations of actual commodity prices, aiding in identifying fair value.

Market Efficiency By replicating the payoffs of assets, the prices of underlying and derivative instruments tend to balance, reducing arbitrage opportunities.

Access to Complex Assets Derivatives enable access to sophisticated financial tools that are difficult to reach directly.

Risks Associated with Derivatives

High Price Volatility Derivatives can be highly volatile, potentially causing significant losses. Their complex design makes pricing extremely difficult or impossible, inherently carrying high risk.

Speculative Nature Since prices are unpredictable, speculative trading can lead to substantial losses.

OTC Market Risks Trading on decentralized OTC markets carries the risk that the counterparty may default.

Contract Complexity Derivatives contracts are often complex, which can lead investors to misunderstand terms and risks.

Who Should Trade Derivatives?

Commodity Exploitation Companies Oil, gold, or mineral extraction companies can use futures or swaps to lock in prices and hedge against volatility.

Hedging Funds and Trading Firms Organizations use derivatives to leverage, protect portfolios, or enhance risk management.

Individual Traders and Investors Knowledgeable individuals can use derivatives to speculate on specific assets. They may leverage to increase potential profits but must accept higher risks.

Conclusion: Trading derivatives requires solid understanding, clear risk management plans, and disciplined trading. Investors should start with small capital, continuously learn, and never trade with money they cannot afford to lose.