What is a derivative? A deep dive into understanding derivatives

When it comes to investing these days, investors have many options, including buying physical goods, investing in funds, or even using instruments that reference other prices. Among all these choices, Derivatives are the most prominent tools, but they also come with high risks. The problem is that many investors do not fully understand derivatives, leading to improper use. This article will help you understand derivatives, which means derivative instruments, thoroughly so you can use them as reasonable risk management tools.

What is a Derivative? A Simple Definition You Need to Know

Derivatives are financial instruments based on contracts where the parties agree today to exchange goods or grant trading rights for goods at a future date.

The interesting aspect of derivatives is that buyers and sellers can decide the price and trading volume in advance, even if the actual goods are not yet in hand. By agreeing on prices beforehand, the derivative price reflects the market’s view of future prices.

When the price of the underlying asset changes between the agreement date and the delivery date, the price difference (Price Difference) becomes an opportunity for profit through speculation.

Real Example: Oil Futures

Suppose in a crude oil futures contract for December 2020, the parties agree on a price of $40 per barrel. This means that the actual delivery of oil at the end of December 2020 will follow this agreed price.

Advantages of pre-agreeing on prices:

• Buyers gain confidence that they can purchase the goods in the desired quantity and price in the future.
• Sellers gain confidence that their products will be bought at the agreed price.

However, the terms of payment and delivery depend on the type of derivative instrument used.

5 Types of Derivatives You Should Know

Derivatives come in various types, each with different usage methods. Let’s look at the details.

1. Futures (Futures Contracts)

Futures are standardized forward contracts where buyers and sellers agree today on quantity and price, but delivery and settlement occur on a future date.

Difference from Forwards: Futures are more standardized, with a fixed contract size, and must be traded through official derivatives exchanges.

Usage Examples: Crude oil futures markets, Brent, or COMEX gold trading.

Advantages:

• High liquidity due to standardized markets.
• Lower risk because trading occurs in regulated markets.

Disadvantages:

• Delivery risk exists, as actual goods may need to be delivered at contract expiry (unless settled with an offsetting contract).
• Contract sizes are large, which may not suit retail investors.

2. Forwards (Forward Contracts)

Forwards are agreements between two parties to buy and sell an asset at a specified price today, with delivery and payment scheduled for a future date.

Special Feature: Forwards are usually direct agreements between counterparties, with no centralized market, and involve actual delivery of the underlying asset according to set terms.

Main Usage: Primarily as risk hedging tools for agricultural products and commodities.

Advantages:

• Helps producers ensure future buyers at a fixed price.

Disadvantages:

• Low liquidity, as negotiations are direct, making them unsuitable for speculation.
• Delivery risk, requiring actual delivery of the asset at maturity.

3. Options (Options Contracts)

Options are contracts that give the holder the right (not the obligation) to buy or sell an underlying asset at an agreed-upon price (Strike Price) within a specified period.

Buyers of options pay a “premium” for this right, while sellers receive the premium but must fulfill the contract if exercised.

Advantages:

• Provides investors with future flexibility.
• Risk is limited to the premium paid, while potential profit is unlimited.
• Highly versatile tools that can be used to effectively limit risk.

Disadvantages:

• Complex instruments requiring detailed understanding.
• Poorly managed strategies may lead to unlimited losses while profits are capped.

4. Swap (Interest Rate and Cash Flow Swap)

Swaps are agreements to exchange cash flows in the future, differing from Futures and Forwards, which are linked to underlying assets. Swaps reference other factors such as interest rates and cash flows.

Usage: Risk management tools for interest rate fluctuations and future cash flow changes.

Advantages:

• Hedge against cash flow risks.

Disadvantages:

• Highly specialized instruments, not typically accessible to retail investors.
• Low liquidity, with no formal exchange market, making trading difficult.

5. CFD (Contract for Difference)

CFD (Contract for Difference) is a derivative that references the price of Futures or other assets but does not involve actual exchange of the underlying asset.

Trading involves only the difference between opening and closing prices, with a small margin and leverage (Leverage) to amplify profits.

Similarity: CFDs are similar to TFEX contracts familiar to Thai traders.

Advantages:

• High leverage allows for amplified gains.
• Low capital requirement.
• High liquidity.
• Simple process, tradable via online apps from anywhere.
• Suitable for both rising and falling markets, ideal for short-term speculation.

Disadvantages:

• High leverage not only amplifies gains but also losses.
• Not suitable for long-term investing.

Benefits of Using Derivatives in Investment

Due to their unique features, derivatives can be used by traders, investors, and funds in various ways:

Lock in Future Returns

Using derivatives involves agreeing on prices and volumes in advance, giving investors confidence that regardless of future price changes, they can buy or sell at the agreed price.

Portfolio Risk Hedging

Certain derivatives like Futures and CFDs are highly liquid and can be used in both Long (bullish) and Short (bearish) positions. Investors can hedge their portfolios against volatility.

Example: An investor holding physical gold can sell it if prices fall, but buying back later incurs fees. Alternatively, they can use Futures or CFDs in a Short position to hedge against risk.

Diversify Investment Portfolio

Since derivatives do not require holding the actual underlying assets, investors can trade various commodities such as oil, gold, and others without physical storage, making diversification more efficient.

Speculate on Price Differentials

CFDs and certain derivatives are highly liquid and easy to trade, providing opportunities for traders to profit from price differentials effectively.

Risks of Derivatives to Watch Out For

Although derivatives offer flexibility and high investment opportunities, they also carry risks that investors must be cautious of:

Leverage Risk

Leverage involves putting up only a portion of the total investment and using a multiplier to increase profit potential. However, it also amplifies the risk of losses if not properly managed.

Protection Methods: Trade with brokers that have negative balance protection, and use stop-loss or trailing stop orders to limit losses.

Delivery Risk

Some contracts require actual delivery of the underlying asset at maturity. Investors should carefully study the terms of each instrument.

Market Volatility Risk

Changes in related factors can cause sharp price swings, e.g., interest rate adjustments can cause gold prices to fluctuate. Without proper risk management, this can lead to significant losses.

Summary: Fully Understand Derivatives

Derivatives are discussed both positively (can make you wealthy) and negatively (can wipe you out). Both outcomes are possible because these tools carry high risks.

However, once you understand the risks and benefits, you can better manage them and utilize derivatives to maximize benefits according to your risk tolerance.

Frequently Asked Questions About Derivatives

Where are derivatives sold? It depends on the type, but generally they are traded on centralized exchanges or over-the-counter (OTC) (OTC). Some derivatives are traded in unregulated markets.

Are Equity Options derivatives? Yes, Equity Options (Stock Options) are derivatives because their value is linked to the underlying stocks. They give the right to buy or sell stocks under specified conditions, with their value directly connected to the stock’s value.