Understanding Derivatives Trading: Definitions, Strategies, and Real-world Examples

What Are Derivatives? The Basics You Need to Know

Derivatives, also known as derivative instruments (derivatives), have existed longer than we think. Looking back in history, single futures contracts appeared as early as the second century BCE in ancient Mesopotamian cities. However, this financial instrument only truly exploded in the 1970s, when advanced pricing models were developed, marking a turning point for the entire derivatives market. Today, it’s hard to imagine a modern financial system without derivatives.

So, what is trading derivatives? Essentially, it is a financial agreement whose value depends entirely on the fluctuations of an underlying asset. This underlying asset could be commodities (crude oil, gold, silver, agricultural products), or financial instruments (stocks, bonds, market indices, interest rates). When the underlying asset fluctuates, the value of the related derivative also changes, making derivatives valuation more complex than regular financial tools.

Common Types of Derivative Securities

The derivatives market features many different instruments, each with its own characteristics. Here are the four main types:

Forward Contract (Forward): This is a private agreement between two parties to buy or sell a specific amount of an asset at a predetermined price, to be executed at a future date. Features include: payments according to an agreed schedule, no intermediary organization, and no transaction fees.

Futures Contract (Future): Essentially, this is a standardized version of a forward contract, listed and traded on official stock exchanges. These contracts are more liquid, with daily market-adjusted prices, and both parties are required to post margin to ensure settlement capability.

Option (Option): This is a unique instrument that gives the holder the (but not obligatory) right to buy or sell an asset at a predetermined price within a certain period. Options are considered the most modern tools among derivatives.

Swap (Swap): This is a transaction between two parties involving the exchange of corresponding cash flows, calculated based on certain principles. These contracts are often traded outside centralized markets.

Two Main Channels for Trading Derivatives

Investors can access derivatives through two different routes:

Over-the-Counter (OTC) Trading (decentralized): OTC derivatives are contracts directly between two parties without third-party oversight. Advantages include lower costs due to no intermediaries, but risks involve counterparty default.

Exchange-Traded Derivatives: These derivatives are listed after a due diligence process. Although trading costs are higher, the rights and obligations of the parties are fully protected.

###Most Widely Used Derivative Tools

CFD (Contract for Difference): This is an agreement between a trader and a broker to pay the difference in the price of an asset from the time the position is opened to when it is closed. CFDs are reliable instruments on OTC platforms because they function as direct contracts. Some features:

• No expiration date, can close positions at any time
• Applicable to over 3000 commodities
• High leverage, allowing trading with low capital
• Relatively low trading costs

Options: Provide traders the right (not obligation) to buy or sell an asset at a specified price within a certain timeframe. Some features:

• Contracts with fixed durations
• Only regulated assets have options
• Larger trading volumes with higher fees than CFDs
• More complex pricing, requiring valuation formulas

The Process to Start Trading Derivatives

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

Step 1 - Open a trading account: Choose a reputable and trustworthy trading platform. This is crucial to avoid risks from the counterparty not fulfilling the contract.

Step 2 - Deposit margin: The amount required depends on the commodity you want to trade and the leverage level you choose.

Step 3 - Execute trades: After depositing sufficient margin, you can place Long or Short orders based on your market predictions, using mobile apps or web interfaces.

Step 4 - Manage your positions: Monitor the market, take profits when profitable, or cut losses to limit damages.

Real-Life Example: Making Money from Gold Price Fluctuations

Imagine a specific scenario. Currently, gold is at a high point $1683 per ounce. Based on analysis and experience, you believe the price will decline sharply once economic conditions stabilize. You want to profit from this volatility without owning physical gold, so you decide to trade a CFD on gold.

Strategy: You open a Short (sell) position at $1683/oz. When the price drops to $1660/oz, you close the position by buying back. Your profit is $23 per ounce.

Impact of leverage: If you use 1:30 leverage:

• The initial capital needed is only $56.1 instead of $1683
• When the price drops $23, your profit is 41% of your initial capital
• But if the price rises to $1700, you lose 30% of your initial capital

Without leverage:

• The required capital is $1683
• When the price drops $23, profit is only 1.36%
• When the price increases by $17, loss is only 1%

This example shows that leverage can amplify both profits and losses.

Benefits of Derivatives Markets

Derivatives have become an indispensable part of modern finance for many reasons:

Risk Management: Derivative tools allow investors to buy assets that move inversely to their current positions, offsetting losses. This was the original purpose of developing these instruments.

Pricing Support: The spot price of futures contracts can serve as a good reference for the market price of commodities.

Market Efficiency: Using derivatives, different cash flows can be replicated. This creates pressure for the prices of the underlying assets and related derivatives to stay balanced, eliminating arbitrage opportunities.

Access to Complex Financial Instruments: Companies can use interest rate swaps to achieve more favorable borrowing rates than direct loans.

Risks to Consider

Like any financial product, trading derivatives involves potential dangers:

High Volatility: Derivative securities are highly volatile and can cause significant losses. The complex structure of contracts makes valuation difficult, sometimes impossible.

Speculative Nature: Due to high risks, derivative prices are hard to predict. Careless speculation can lead to substantial losses.

Counterparty Risk (with OTC): If trading on decentralized platforms, you face the risk that the counterparty may default at settlement.

Who Should Participate in Derivatives Trading?

Derivatives serve different groups:

Exploiting Companies: Commodity producers (oil, gold, Bitcoin) can lock in prices using futures or swaps to hedge against price fluctuations.

Investment Funds: Hedge funds and trading firms use derivatives to leverage, protect portfolios, or enhance yields.

Individual Traders: Independent traders use derivatives for speculation and maximizing profits through leverage.

Derivatives are powerful tools but require knowledge and discipline to use effectively and safely.