Derivative Instruments: How They Work and When to Use Them

Introduction to Derivatives in Modern Markets

After investing for several months in conventional operations — direct buying and selling of stocks, cryptocurrencies, or commodities — many investors seek to expand their strategies toward more sophisticated instruments. This is where financial derivatives become relevant. These contracts offer potential for higher returns compared to traditional trading, while simultaneously serving as tools for protection against adverse market movements. Financial derivatives facilitate portfolio diversification, allow for risk exposure limits, and open access to investment opportunities with significant yields. Understanding these instruments provides multiple possibilities in the financial realm.

Definition and Characteristics of Derivatives

Derivatives are contracts whose value is based on the price of an underlying asset, without requiring its physical purchase or sale. Their nature is speculative and they require intermediation by a broker acting as counterparty, ensuring the proper functioning of the contract.

These instruments present distinctive features compared to traditional trading:

• Reduced commissions: in structures like CFDs, operational costs are lower
• Greater performance potential: futures and options offer amplified gains
• Risk management: allow offsetting exposures from other positions
• Strategic flexibility: facilitate both bullish and bearish positions

Assets for Trading with Derivatives

Stock Derivatives

Contracts on stocks are attractive when there is deep knowledge of the company’s performance. They are frequently traded around dividend distribution dates, product launches, or sector demand projections.

Relevant asset examples: Advanced Micro Devices (AMD), Apple, Microsoft, and other tech corporations.

Currency Derivatives

Geopolitical and macroeconomic analysis are fundamental. Investors anticipate currency movements based on the global context, executing operations through futures or options.

Key pairs: EUR/GBP and other major currency pairs.

Commodity Derivatives

Commodities experience significant fluctuations due to supply and demand variations. Futures and options on oil, natural gas, and precious metals like gold offer opportunities if risks are properly assessed.

Cryptocurrency Derivatives

Emerging assets in markets, cryptocurrencies have derivatives for speculative operations. You can invest in futures for potential bullish movements or options to hedge positions against unexpected volatility. Examples: Bitcoin, SHIB/USD.

Main Types of Derivatives

CFDs (Contracts for Difference)

CFDs are derivatives although they are often classified as traditional operations. They function similarly to buying and selling assets but as contracts, which reduces commissions and increases agility.

Operation: An investor opens a buy position on Bitcoin at $30,000. When the price rises to $35,000, they close the position. The profit results from $5,000 per unit.

Advantages: low commissions, similarity to conventional trading, quick execution.

Futures

In these contracts, the buyer commits to acquiring the asset on a specific date and at a predetermined price. Gains are generated if the price rises more than expected, and losses if it does not reach the agreed price.

Features:

• Obligation to buy on a set date
• More competitive price the further the date
• Higher risk due to prediction difficulty over long periods

Example: Agreement to buy Microsoft shares at $300 in three months. If the price reaches $320, a gain of $20 per share. If it drops to $250, a loss of $50 per share.

Options

Options grant the right, not the obligation, to buy or sell an asset at a specific price on a set date. They are secured by a deposit (premium) that is lost if the option is not exercised.

Call options (Calls)

Allow purchasing an asset at a set price. Profitability occurs when the market price exceeds the strike price.

Example: Call option to buy Apple shares at $180 in three months. If the price reaches $200, it is exercised, generating $20 profit per share. If it drops to $150, the option is abandoned, losing only the premium.

Put options (Puts)

Work inversely, allowing to “sell” an asset at a fixed price. Profit exists when the price falls below the strike price.

Example: Put option to sell Santander shares at €3 per share in three months. If it drops to €2.5, profit of €0.5 per share. If it rises to €3.5, the option is abandoned with limited loss to the premium.

Swaps

Interest rate exchanges mainly accessible to institutional investors. They are used to balance risks between different financial operations.

Example: Santander and BBVA exchange interest rates. Santander has a variable-rate loan, BBVA a fixed-rate. Result: BBVA accesses a more competitive rate, Santander reduces variability risk.

Analysis of Advantages and Disadvantages

Advantages of financial derivatives:

• Potential for significant benefits
• Position protection with contained costs (especially options)
• Lower commissions than traditional operations
• Greater operational agility

Disadvantages:

• High volatility risk
• Greater technical complexity
• Total loss risk in certain scenarios (futures)
• Requires specialized knowledge

Practical Investment Strategies

Financial derivatives work optimally when operated alongside traditional investments.

Hedging strategy with futures: An investor owns stocks with a bullish outlook but anticipates a temporary correction. They contract futures to sell the same asset at a specific price. If it rises, they profit from the original position. If it falls, they receive the guaranteed futures price.

Protection strategy with options: Similar to the previous, but with limited risk. If the market moves favorably, they realize full gains. If not, they only lose the option premium.

Recommendations for Trading with Derivatives

These instruments present considerable volatility and require substantial expertise. They are considered advanced and should only be used with thorough knowledge.

Recommendation 1: Use derivatives as hedging instruments

The most prudent application is to support existing operations. If you invest in an asset, contract opposite directional derivatives to prevent significant losses.

Recommendation 2: Prioritize lower-risk derivatives

Options are more attractive as they limit risk to the premium. Futures offer more competitive prices but involve obligations with higher exposure.

Recommendation 3: Analyze long-term trends

The further the expiration date of the derivative, the greater the importance of fundamental analysis. Understand the trends well before committing to medium or long-term horizons.

Conclusion

Not all investors are prepared to operate financial derivatives, but those who are gain access to higher profitability opportunities. Futures allow more competitive prices with higher risk. Options offer moderate benefits with controlled risk.

The key lies in using them as complements to traditional strategies, reducing total risk exposure while amplifying profit potential. Many experienced investors incorporate financial derivatives as hedging tools, protecting their main operations and optimizing results.