Complete Guide to Derivative Financial Products: Five Key Tools Explained and a Beginner's Introduction

What Are Derivative Financial Instruments?

Derivative financial products (English: Derivatives) are tradable financial contracts whose value follows the price fluctuations of the underlying assets. These underlying assets can include stocks, bonds, commodities, indices, virtual currencies, interest rates, and other assets. As the value of the underlying asset changes, the price of the derivative financial product also fluctuates accordingly.

Common types of derivatives mainly include: futures, options, contracts for difference (CFDs), forward contracts, and swaps.

Core Features of Derivative Products

Derivative financial products have the following three prominent characteristics:

High Leverage Effect: Investors only need to pay a small margin to participate in trading, controlling larger assets with less capital, making trading more flexible and agile.

Risk Management Tools: Derivatives enable investors to profit from market volatility predictions of price changes, and can also be used for hedging and risk transfer, effectively avoiding losses caused by market fluctuations.

Enhancing Market Efficiency: Derivatives increase market liquidity, promote price discovery, optimize resource allocation, and make market operations more efficient.

Example Illustration

Suppose you want to invest in 1 BTC (current price $95,000), with two options:

1. Direct Purchase: Buy 1 Bitcoin on a cryptocurrency exchange, wait for the price to rise, then sell for profit.
2. Trading Derivatives: Trade BTC via CFDs, requiring only a small margin, allowing trading of equivalent assets, supporting both long and short positions, without wallet storage.

Through derivative financial products, investors can gain the same exposure with less capital. Many investors hold both stocks and stock CFDs; when stock prices fall, they offset losses with short positions in CFDs, achieving risk hedging.

Why Invest in Derivative Financial Products?

Investors mainly pursue three purposes when trading derivatives: speculation, hedging, and arbitrage.

Hedging Risks: Many large global companies use derivatives to reduce risk exposure. For example, oil companies can lock in future oil prices via futures contracts; import/export firms can hedge exchange rate risks through forward contracts and currency swaps.

Profit from Speculation: Derivatives offer higher predictability, and investors can leverage small capital to generate large returns. Since derivatives require only a small margin, investors can leverage to trade large quantities of assets.

Arbitrage Opportunities: In futures markets, investors can analyze arbitrage space based on upstream and downstream industry chain relationships. For example, when iron ore prices fall, steel costs are expected to decrease, enabling short-selling steel futures for profit.

Many institutional investors allocate various derivatives in their portfolios, but derivatives are usually not core holdings; core assets remain safe assets like government bonds. Derivatives are mainly used to enhance returns and manage risks.

Comparison of Advantages and Disadvantages of Derivative Financial Products

Main Advantages

Ample Liquidity: Derivatives can be traded on exchanges or over-the-counter (OTC), providing more trading opportunities and options, significantly increasing market liquidity.

Effective Hedging: Can effectively hedge market risks such as interest rate risk, exchange rate risk, and price risk, reducing investment losses.

Lower Transaction Costs: Derivative trading costs are usually lower than those of the underlying assets; futures and options have relatively low commissions and no stamp duty.

Leverage Amplifies Returns: Using margin systems to magnify capital efficiency, increasing operational flexibility and strategic options.

Main Risks

Complex Rules: Derivative mechanisms are complex, requiring investors to have relevant professional knowledge and practical experience.

High Risks: Due to leverage, risk is proportional to return. Adverse market movements can lead to significant losses or even forced liquidation.

Counterparty Risk: Especially prominent in OTC trading, where one party may fail to fulfill contractual obligations, increasing credit default risk.

High Volatility: Derivatives are complex in design; extreme valuation is difficult to predict, making them high-risk tools. Improper speculation can lead to huge losses.

Detailed Comparison of the Five Major Derivative Instruments

Detailed Explanation of the Five Major Derivative Products

① Futures Contracts (Futures)

Futures give investors the obligation to buy or sell an asset at a predetermined price at a future date.

Standardized Features: Futures are listed on futures exchanges as standardized financial contracts, with uniform contract value, trading volume, and settlement time, facilitating centralized bidding.

Leverage Trading Mechanism: Investors pay a margin to control larger asset quantities, amplifying returns but also increasing risk.

Trading Flexibility: Futures can be traded on the secondary market; investors can close positions early or settle in cash at maturity.

Note: Futures must be settled before the last trading day; individual investors generally settle in cash. To avoid delivery, positions should be closed before expiry. If not closed timely, brokers will forcibly close positions at market price on expiry. As expiry approaches, margin requirements increase; thus, it is not recommended for individuals to buy near-expiry futures.

② Options (Options)

Options give the buyer the right, but not the obligation, to buy or sell an asset at an agreed price on a future date.

Standardized Design: Options are standardized financial instruments, clearly specifying underlying assets, strike prices, and expiry dates.

Leverage Trading Features: Investors pay a margin to trade options; margin depends on contract value and exchange requirements. Buyers pay a premium for the right to purchase the underlying at a preset price in the future.

Diverse Strategies: Investors can buy or sell rights, including call and put options. Combining different expiry dates and strike prices allows for complex trading strategies.

Main Disadvantages: Options trading mechanisms and strategies are relatively complex; lack of professional knowledge makes effective operation difficult. Options lose value over time, especially near expiry, and most expire worthless; traders need to profit before expiry to realize gains.

③ Contracts for Difference (CFDs)

CFDs are derivative products that do not grant investors actual ownership of the underlying asset rights; trading is based on price movements rather than actual possession.

CFDs are agreements between brokers and traders to exchange the difference in the price of the underlying asset between opening and closing positions, with profits or losses depending on price changes.

Non-standardized Features: CFDs are traded OTC, with no centralized exchange; contract specifications are flexible, with low entry barriers, high leverage, suitable for various strategies.

Leverage Trading Convenience: Investors only need to pay a small part of the contract value as margin to control larger assets.

No Time Limit: CFDs have no expiry date; positions can be held indefinitely, trading based on price movements, reducing costs and risks of holding actual assets. Supports both long and short positions.

Important Reminder: Since OTC trading is unregulated, choosing a regulated and reputable platform is crucial. Liquidity may be low for some assets, leading to sharp price swings and slippage, affecting trading outcomes.

④ Forward Contracts (Forwards)

A forward contract is a private agreement between two parties to buy or sell an asset at a future date at a predetermined price, without intermediary involvement.

Non-standardized Customization: Forwards are directly negotiated between buyer and seller, with flexible terms tailored to their needs.

High Flexibility: Contract terms, including underlying asset, delivery date, and price, can be customized.

Suitable for Long-term Investment: Forwards are typically long-term contracts, suitable for long-term hedging or investment.

Risk Warning: Forwards are private OTC agreements, with counterparty default risk.

⑤ Swaps (Swaps)

Swaps, also called interest rate swaps or exchange agreements, are contracts where two parties agree to exchange future cash flows.

Participants exchange assets based on mutually agreed terms, such as interest rate swaps, currency swaps, commodity swaps, or equity swaps.

For example, currency swaps involve exchanging principal in different currencies, helping hedge exchange rate risks.

Non-standardized Features: Swaps are negotiated directly between parties, customizable per needs.

Strong Flexibility: Contract terms are flexible and tailored.

Long-term Nature: Swaps are usually long-term, involving exchange of flows over a period.

Operational Complexity: Swaps are often used by financial institutions, involving complex legal documents, accounting, and regulatory compliance, increasing transaction costs. OTC nature entails counterparty risk.

Risk Analysis of Derivative Financial Products

High Volatility Risk: Derivatives are complex, with extreme valuation difficult to achieve; high risk is inherent.

Speculative Risk: Due to their risk profile and large price swings, derivatives are hard to predict; improper speculation can lead to huge losses.

Counterparty Risk: OTC trading involves the risk that the counterparty may default; choosing regulated, reputable platforms is vital.

Liquidity Risk: Some derivatives markets have low liquidity, making quick liquidation or favorable pricing difficult.

Core Differences Between Derivative Products and Stock Trading

Stock trading occurs on centralized securities exchanges with unified rules, offering high liquidity and security. Derivatives are more complex in design and offer more diverse trading strategies.

Comparison between individual stock trading and stock CFDs:

Compared to traditional trading, derivatives offer higher flexibility and speculation potential, but are high-risk, high-reward tools. Investors should choose according to their risk appetite and objectives.

Suitable Investors for Derivative Financial Products

Many participants engage in derivatives trading, including:

Producing Companies and Miners: Oil producers, gold miners, crypto miners, etc., can lock in prices via futures to hedge against price volatility.

Hedge Funds and Asset Managers: Use derivatives to leverage positions, hedge risks, or enhance portfolio management.

Traders and Individual Investors: Use derivatives for short-term speculation, leveraging to increase profits quickly, with risk management in mind.

Import/Export Companies: Use forward contracts and currency swaps to hedge exchange rate risks, stabilizing profits.

Choosing the Right Derivative Trading Platform

Before selecting a platform, investors should clarify which derivatives they want to trade. There are three main channels:

General Brokers: Offer warrants and options, listed on exchanges, with strict evaluation, complex rules, and strict restrictions.

Futures Brokers: Mainly provide futures and options, also exchange-based.

OTC Brokers: Also called over-the-counter (OTC) markets, where contracts are executed directly between parties. Due to lack of intermediaries, contracts are non-standardized, with fewer restrictions, lower costs, but higher counterparty risk.

OTC derivatives include futures, options, CFDs, etc. When choosing OTC platforms, opening an account and understanding trading rules and fee structures (margin, commissions, settlement) are essential.

Key Factors in Platform Selection:

• Regulatory license (check for relevant financial licenses)
• Range of trading products (coverage of desired derivatives)
• Transparency of fees (spreads, margins, overnight fees)
• Customer service quality (account opening speed, responsiveness)
• Educational resources (learning materials)
• Trading tools (technical analysis, automation)
• Security measures (negative balance protection, risk management tools)

Core Differences Between CFDs and Futures

1. Contract Duration: Futures have fixed expiry dates; CFDs have no expiry limit.
2. Physical Delivery: Futures may involve physical delivery; CFDs do not.
3. Transaction Costs: Futures involve commissions and taxes; CFDs usually only spreads and overnight fees.
4. Trading Specifications: Futures have minimum trading sizes and fixed specs; CFDs have smaller minimum amounts and flexible specs.

Basic Guide to Trading Derivative Products

For beginners, understanding the basic trading process is crucial:

Step 1: Open an Account: Choose a regulated platform, complete identity verification and account setup.

Step 2: Deposit Funds: Transfer funds into the trading account as margin and trading capital.

Step 3: Market Analysis: Study technical and fundamental aspects of the underlying asset, formulate a trading plan.

Step 4: Place Orders: Based on analysis, decide to go long (bullish) or short (bearish), set stop-loss and take-profit levels.

Step 5: Risk Management: Monitor positions continuously, adjust leverage and size timely to avoid excessive risk exposure.

Step 6: Close Positions: Close at target or stop-loss prices to realize profits or cut losses.

Key Recommendations for Derivative Investment

• Deepen knowledge of derivatives, understanding their features and risks.
• Start small, gradually increasing investment size and complexity.
• Develop clear risk management plans, setting stop-loss levels.
• Do not chase trends; select tools based on personal capacity and risk tolerance.
• Choose regulated platforms to ensure fund safety.
• Regularly review trading records and summarize experience.
• Avoid excessive leverage; control individual losses.
• Maintain rationality, avoiding emotional trading.