What is a Derivative? All about derivative instruments that traders need to know

Why Study Derivatives?

The financial markets today have developed significantly, offering a wide range of investment tools. For example, if you want to invest in gold, investors can choose to buy directly from (Gold Spot) or invest through funds, or even use CFDs, which are a type of derivative.

Among all these, derivatives are known for their unique characteristics: high risk but also high potential for income and risk management. However, many investors still do not fully understand how to properly use derivative instruments. This article will explain the details, types, and best practices for using derivatives to maximize trading benefits.

Derivatives - Basic Meaning

Derivative is a financial instrument created from a contract or agreement that allows participants to buy, sell, or have the right to buy or sell an underlying asset at a future date.

The key feature of derivatives is that they give buyers and sellers the opportunity to agree on prices and quantities in advance, even before the actual asset is in hand. This way, the price of the derivative reflects expectations about the future price of the underlying asset. When the price changes between the agreement date and the delivery date, it creates an opportunity for profit from price differences.

Example of Usage

Imagine a futures contract for West Texas crude oil, agreed upon in December 2020 at $40 per barrel. This means that by the end of December 2020, the delivery of crude oil will be at that price for sure.

Benefits for Buyers: Confidence that they will receive the product in the desired quantity and price without worrying about market fluctuations.

Benefits for Sellers: Confidence that the product in production will be sold at the offered price.

Payment and delivery conditions depend on the type of derivative chosen.

Types of Derivatives Traders Should Know

Derivatives come in many types, each with different features and uses.

Forward - The simplest contract

A forward is a straightforward agreement to buy or sell an asset. The investor and counterparty agree on a price today, with actual delivery and payment happening in the future.

Forwards are usually direct agreements between two parties, involving the delivery of the actual asset. They tend to have low liquidity but are often used for price risk hedging, especially in agriculture and commodities.

Futures - Standardized version of Forward

Futures improve upon forwards by being more standardized. These instruments have fixed contract sizes and are traded on official futures exchanges.

Examples include: crude oil futures, Brent crude, or gold and metal futures on the MEGA exchange.

Options - Rights contracts

Options give the holder the (right, not obligation), to buy or sell an asset in the future. The buyer pays a premium for this right.

Option sellers, after receiving the premium, are obligated to fulfill the contract if the buyer chooses to exercise the option.

Swap - Cash flow exchange

Swaps are agreements to exchange future cash flows. Unlike other derivatives, swaps are often used to manage interest rate and cash flow risks.

CFD - Contract for Difference

CFDs differ from other derivatives because they do not involve the exchange of the actual underlying asset. Instead, they are contracts that reference the price of futures or other assets, with settlement based only on the difference between opening and closing prices.

Advantages of CFDs:

• Use of leverage to amplify profits
• Can trade both rising and falling markets
• High liquidity
• Easy to understand and trade via online applications

Disadvantages:

• Leverage can also amplify losses
• Not suitable for long-term investing

Comparison of Derivative Types

| Type | Purpose | Advantages | Disadvantages | |---|---|---|---| | CFD | Speculate on price differences | High leverage • Low capital requirement • High liquidity • Easy trading | Losses can be magnified • Not suitable for long-term | | Forward | Price risk hedging | Certainty of price | Low liquidity • Delivery risk | | Futures | Formal risk hedging | High liquidity • Standardized market | Large contract sizes | | Options | Risk hedging and speculation | Exercise rights • Limited risk • Unlimited profit potential | Complex • Requires study | | Swap | Cash flow and interest rate hedging | Interest rate hedge | Specific to the counterparty • Low liquidity |

How to Benefit from Derivatives?

1. Lock in future prices

By agreeing on a price in advance, investors can be confident that regardless of market fluctuations, they can buy or sell at the agreed price.

2. Hedge investment portfolios

Futures and CFDs are highly liquid and can be used for risk management. For example: investors holding large amounts of gold can use futures or CFDs in a short position to hedge against falling prices without selling the actual gold and incurring brokerage fees.

3. Diversify investments

Since derivatives allow trading without owning the actual assets, investors can access hard-to-possess commodities like oil, gold, and other commodities more easily, enabling effective portfolio diversification.

4. Speculate on price movements

Some derivatives, especially CFDs, are highly liquid and suitable for traders aiming to profit from price changes, as they can be bought and sold quickly and easily.

Risks of Derivatives to Be Aware Of

Leverage risk

Using leverage allows investors to increase their investment with less capital, but it also amplifies potential losses. If the market moves against the position and risk is not managed properly, losses can exceed the initial investment.

Mitigation: Choose brokers with negative balance protection and set appropriate Stop Loss / Trailing Stop levels.

Delivery risk

Some instruments, such as Forward and Futures, may require physical delivery. Investors should thoroughly understand the terms of each instrument before trading.

Market volatility risk

Various factors can cause sharp price changes, such as interest rate adjustments, which can lead to significant gold price fluctuations. Without proper risk management, losses can be substantial.

Common Questions Traders Ask

Where can I trade derivatives?

It depends on the type of derivative. Usually, trading occurs on centralized exchanges or OTC markets. (Over-The-Counter) Some instruments are traded in unregulated markets.

Is an Equity Option considered a derivative?

Yes, an equity option is a type of derivative. It is a contract giving the right to buy or sell shares under agreed terms. The value of an equity option is linked to the underlying stock price.

Summary

Derivatives are important financial instruments that provide investors with opportunities for risk hedging, diversification, and speculation. However, derivatives carry high risks due to their nature and the use of leverage.

If investors understand the risks and benefits well, and apply proper risk management tools, they can maximize the advantages of derivatives according to their risk appetite.