What Are Derivative Trades? A Detailed Guide and Real-Life Examples

Derivatives Tools: Basic Concepts

Derivatives (or called derivatives) are financial instruments whose value is determined based on the fluctuations of an underlying asset. This asset can be physical commodities (crude oil, gold, silver, agricultural products), financial assets (stocks, bonds, stock indices), or even interest rates. When the price of the underlying asset changes, the price of the derivative instrument also fluctuates accordingly, making their valuation more complex than traditional financial tools.

Although what is derivatives trading may seem like a modern concept, futures contracts have existed since the second century BC in Mesopotamia. However, this instrument only gained significant development from the 1970s when advanced pricing techniques were invented. Today, the derivatives market is an integral part of the global financial system.

Main Types of Derivative Securities

The derivatives market features various instruments, each with its own characteristics:

Two Main Methods of Derivatives Trading

Investors can access derivatives trading through two different channels:

OTC Market )Over-the-Counter(: These are contracts made privately between two parties without centralized regulation. Transaction costs are usually lower due to the absence of third-party involvement. However, this also entails risks: if one party fails to fulfill the contract at maturity, the investor may face difficulties.

Regulated Exchange: Derivative instruments listed here must undergo an approval process before trading. Although transaction fees are higher, participants are protected regarding rights and obligations. This is a safer platform for investors seeking security.

CFD and Options: The Most Popular Instruments

In the market, the two most widely used derivatives are CFDs and Options:

CFD )Contract for Difference(: An agreement between a trader and a broker to calculate the difference in the price of an asset between the opening and closing of a position. CFDs are the most reputable instruments on OTC platforms because they are direct contracts between investors and brokers.

Option )Option Contract(: This tool grants traders the right )but not the obligation( to buy or sell an asset at a specified price within a certain timeframe. It is the most modern instrument on centralized exchanges.

The main differences between these two tools:

Detailed Derivatives Trading Process

To start trading derivatives, investors should follow these steps:

Step 1: Choose a Reputable Trading Platform

Selecting a platform is crucial as it directly affects your capital safety. A reputable platform helps you avoid risks from non-compliant parties. Choose those with strong financial capacity and a long operational history.

Step 2: Open a Trading Account

After selecting a platform, proceed to register a trading account. This process typically includes identity verification and providing basic information.

Step 3: Deposit Initial Margin

The margin amount depends on the number of commodities you wish to trade and the leverage level used. Prepare thoroughly for this stage.

Step 4: Place a Trading Order

Based on your market analysis, place a Long )predicting price increase( or Short )predicting price decrease( order via the trading app or web version.

Step 5: Manage Your Position

After opening a position, monitor the market, take profits when targets are reached, or cut losses if the market moves against your forecast.

Real Example: Gold Derivatives Trading

Imagine you predict that the current gold price at its peak )$1683/oz$1683 will decline sharply as the economic situation stabilizes. You want to profit from this volatility but do not own physical gold. The solution is to use a gold CFD.

Step 1: Open a Short Position

Since you expect gold prices to fall, open a Short position at $1683/oz. Sell gold at the current price and wait for the price to drop to buy back at a lower level, earning the difference.

Step 2: Use Leverage

Gold at $1683/oz is too high relative to your capital, so you decide to use 1:30 leverage. This reduces the initial capital needed by 30 times, from about $56.1.

Profit Scenario:

Suppose gold drops to $1660/oz and you close the Short position:

• With 1:30 leverage: Profit of $23, equivalent to 41% of initial capital
• Without leverage: Profit of $23, equivalent to 1.36% of initial capital

Loss Scenario:

If gold rises to $1700/oz and you decide to cut losses:

• With 1:30 leverage: Loss of $17, losing 30% of initial capital
• Without leverage: Loss of $17, losing 1% of initial capital

This example clearly shows: leverage can amplify profits but also increases risks proportionally.

Benefits of Derivatives Trading

The derivatives market has expanded widely because it offers several key advantages:

Hedging Risks: Initially, derivatives were developed to help businesses and investors protect against price volatility. You can buy an asset that moves inversely to your holdings, offsetting potential losses.

Asset Pricing: The spot price of futures contracts can serve as an approximation of the actual commodity price.

Market Efficiency: Using derivatives helps replicate the payout levels of assets, ensuring that the prices of the underlying assets and related derivatives stay balanced, avoiding arbitrage opportunities.

Access to Difficult Assets: Through interest rate swaps, a company can obtain more favorable interest rates than direct borrowing.

Potential Risks of Derivatives

However, derivatives trading is not without risks:

High Volatility: Derivative instruments can experience significant price swings, leading to substantial losses. The complex design of contracts makes valuation extremely difficult, sometimes nearly impossible.

Speculative Nature: Due to high risks and large price fluctuations, derivatives are often considered speculative tools. Unpredictable prices and irrational speculative decisions can lead to major losses.

OTC Contract Risks: If trading on decentralized platforms, there is a risk that the counterparty may default on the contract.

Who Should Trade Derivatives?

Various groups can benefit from derivatives trading:

Commodity Exploitation Companies: Oil, gold, Bitcoin, or other commodity producers can use futures or swaps to lock in prices and hedge against volatility.

Hedging Funds and Trading Companies: These organizations use derivatives to leverage, protect portfolios, or enhance risk management.

Individual Traders and Investors: They use derivatives to speculate on price movements of assets and may leverage to increase potential profits.

Understanding the nature of derivatives trading, the types of instruments, trading processes, and risk management strategies are essential steps before entering this market. Be prepared to continuously learn to improve your trading skills.