What are derivatives? The complete guide for investors

Introduction: Rapidly Evolving Financial Instruments

In today’s investment world, derivatives have become one of the most discussed and scrutinized tools. Some see them as the key to increasing profits, while others avoid them due to perceived high risks. The truth is, both perspectives are somewhat correct because derivatives are complex instruments that require deep understanding.

Whether you’re looking to hedge your investment portfolio or speculate on price movements, derivatives offer numerous opportunities. However, they demand careful study and risk management.

Derivatives: Definition and Basic Principles

Clearly define the meaning

Derivatives, also known as Derivative, are financial instruments that are contracts or agreements between two parties, created today, but with the exchange of underlying assets or the right to buy or sell the underlying asset (Underlying Asset) occurring in the future.

What makes derivatives different from regular investments is that trading participants can agree on prices and quantities in advance, even if they do not yet own the actual goods.

How it works

By agreeing on future prices, the value of derivatives reflects market expectations about future prices of the underlying goods. When the delivery date arrives and the actual prices have changed from the agreed-upon price, a gap arises, allowing speculators to profit from the price difference.

Practical example: A futures contract in the crude oil market (WTI Crude Oil) in December 2020 was agreed at $40 per barrel. This means that at the end of December 2020, delivery will be made at $40 per barrel, regardless of the actual market price at that time.

For buyers, this provides certainty of receiving the desired quantity at a known price. Sellers are assured that the goods in production will have buyers at a fair price.

Classification: The Five Main Types of Derivatives

1. Forward Contracts(

This is the simplest form of derivatives. Forward contracts are direct agreements between two parties to buy and sell goods, with a current price agreed upon and a commitment to deliver and settle at a specified date.

Advantages:

• Used as a tool to hedge future commodity prices
• Popular in agriculture and commodity trading

Disadvantages:

• Low liquidity due to direct bilateral agreements
• Not suitable for short-term speculation
• Risk of non-compliance with the contract

) 2. Futures Contracts###

Futures are similar to forwards but differ significantly in that trading occurs on a formal (Exchange) with standardized specifications.

Features:

• Contract size is standardized
• High liquidity
• Reputable markets, such as West Texas Intermediate crude oil or COMEX gold markets

Advantages:

• Easy to close positions by executing offsetting contracts
• Standardization reduces counterparty risk

( 3. Options)

Options or rights contracts give the holder more freedom. The buyer pays a “premium” for the right, which they can choose to exercise or not in the future. The seller must fulfill the contract if the buyer exercises the right.

Advantages of options:

• Limited risk to the premium paid
• Unlimited profit potential
• Can be used with underlying assets for various hedging strategies

Challenges:

• Complex valuation and selection
• Requires deep understanding of “Greeks” and other factors affecting prices

4. Swap Agreements(

Swaps are agreements to exchange future cash flows, differing from other derivatives that are often linked to underlying commodities.

Uses:

• Managing interest rate and future cash flow risks
• Mainly used by financial institutions and large corporations

Limitations:

• Low liquidity; no dedicated trading market
• Suitable for those with advanced financial knowledge

) 5. Contracts for Difference (CFD)###

CFD differs from other derivatives in that there is no physical exchange of goods. Instead, it involves trading based on the price of futures or other underlying assets, settling only the difference between opening and closing prices.

Special features:

• High leverage to amplify profits
• Profitable in both rising and falling markets
• High liquidity and convenient trading via apps
• Not suitable for long-term investments

Comparison Table: Different Types of Derivative Instruments

Benefits for Investors

( 1. Lock in Expected Returns

Derivatives allow investors to set prices and quantities in advance. Regardless of market fluctuations, they can trade according to their agreements.

) 2. Effective Risk Hedging

Some derivatives, such as futures and CFDs, are highly liquid and suitable for hedging. For example, an investor holding physical gold can use futures or CFDs in a short position to hedge against price drops.

3. Diversify Investments

Since derivatives do not require ownership of the actual goods, investors can access hard-to-buy commodities like oil, gold, or other resources more easily.

( 4. Speculate on Volatility

Traders can use CFDs or futures to profit from price movements by opening high-leverage positions over short periods.

Risks to Understand

) Leverage Risks

Using leverage can amplify gains but also losses. If the market moves against the position and risk management is poor, the entire investment can be lost quickly. Investors should choose brokers with negative balance protection and use stop-loss/trailing stop tools.

Delivery Risks

Some derivatives, like futures, require physical delivery if the contract reaches expiration. Investors must carefully review the terms of each instrument.

Market Volatility Risks

External factors such as central bank interest rate adjustments can cause rapid and significant price swings, e.g., in gold. Without proper risk management, such volatility can lead to losses.

Liquidity Risks

Certain derivatives, like swaps, have low liquidity and may be difficult to buy or sell when needed.

Practical Scene: Where to Buy Derivatives?

Different derivatives have different markets:

• Futures: Traded on centralized, regulated markets like CME
• CFD: Traded via online platforms of various brokers
• Options: Over-the-counter (OTC) markets or regulated exchanges
• Swaps: Mostly OTC between financial institutions

Frequently Asked Questions

Are stock options derivatives?@

Yes, stock options are contracts that give the right to buy or sell stocks at a specified price and time. Their value is directly related to the underlying stock price.

Who can trade CFDs?@

Anyone aged 18 and above with a trading account can trade CFDs, but they should study the risks beforehand.

How are derivatives different from betting?@

Derivatives are financial instruments based on real underlying values, while betting is merely predicting outcomes without actual underlying assets.

Summary

Derivatives are financial tools that carry both potential and risks. They can be used for hedging or speculation, depending on how they are employed.

The key takeaway is that before engaging with derivatives, you must thoroughly understand how they work, what risks they entail, and how to manage those risks.

Investing with knowledge limits risks, and following a clear investment plan is the key to maximizing benefits from derivatives according to individual risk tolerance.