Financial Derivatives: Tools Every Trader Must Know

In today’s investment industry, choosing the right financial instruments is a key to success. Whether investing in gold, stocks, or commodities, investors have many options, from spot trading in the current market to more complex derivative tools. These instruments each have their own characteristics and risks, especially derivatives, which are known to carry high risk. However, many people still do not understand the true nature behind this powerful tool.

This article will take you deep into Derivatives (Derivative), explaining what they are, their types, and how they can help traders. So you can utilize these tools effectively and manage risks well.

What are Derivatives? A Deep Meaning

Derivatives (Derivative) or derivative instruments are financial tools that arise from contracts or agreements made today, which specify that an underlying asset will be bought or sold in the future.

The key point of derivatives is that they allow buyers and sellers to agree on prices and quantities in advance, even though the actual goods are not yet in hand. This way, the price of derivatives reflects the market’s view of future prices of the underlying assets.

Practical Example: Imagine a West Texas crude oil futures contract for December 2020, agreed at $40 per barrel. This means that on the delivery date, oil will be bought or sold at $40 per barrel, regardless of the current market price.

Clear benefits:

• Buyers are assured of a fixed price for the product.
• Sellers are assured of a buyer at the agreed price.

Main Types of Derivatives

Derivatives come in various forms, each designed for different purposes.

( 1. Forward Contracts )Forwards###

Forwards are private agreements between two parties to buy and sell a commodity, paying and receiving the actual goods in the future.

Characteristics:

• Non-standardized; price, quantity, and delivery date are negotiable.
• Low liquidity due to being private agreements.
• Commonly used in agriculture and commodities.
• Actual delivery is required.

( 2. Futures Contracts )Futures###

Futures are similar to Forwards but are “standardized” for convenience.

Main differences:

• Have standardized contract sizes.
• Traded on official exchanges, e.g., crude oil, gold markets.
• High liquidity; contracts can be closed before maturity.
• Can use margin and leverage.

( 3. Options )Options###

Options have a special feature: you buy a “right,” not an “obligation.”

How it works:

• The buyer pays a “premium” for the right to buy (Call) or sell (Put) the underlying asset in the future.
• The buyer can choose whether to exercise this right.
• The seller must fulfill the contract if the buyer exercises the option.

Advantages: Limited risk to the premium paid, but unlimited profit potential.

( 4. Swaps )Swap###

Swap is an agreement between two parties to exchange cash flows in the future.

Uses:

• Often used to hedge interest rate risks.
• Manage long-term cash flow risks.
• Relatively complex and used mainly by financial institutions.

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

CFD is a completely different instrument from other derivatives.

What makes it special:

• No actual delivery of goods.
• Trade to profit from price changes.
• The difference between opening and closing prices is profit or loss.
• Can use high leverage; trade both upward and downward.
• High liquidity and easy to trade.

Comparing Types of Derivatives

How Traders Can Use Derivatives

( 1. Lock in future returns

Real example: A farmer knows he will harvest wheat in 3 months. Instead of guessing future prices, he can use Futures to lock in the price now.

) 2. Hedge investment portfolios

Investors holding large amounts of gold can use CFDs in a Short position to hedge against falling gold prices, benefiting from both sides.

3. Diversify investment risks

Derivatives offer opportunities to trade various commodities like oil, gold, rice, which are often difficult to hold physically.

4. Speculate on price differences

CFD is a favorite instrument for short-term traders because leverage amplifies profits, but risks also increase, so risk management is crucial.

Risks Traders Must Be Aware Of

Leverage Risk

Leverage is a double-edged sword: it amplifies gains but also losses.

Protection methods:

• Choose brokers with Negative Balance Protection.
• Always use Stop Loss.
• Do not fully utilize leverage.

Market Volatility Risk

Prices of some commodities can change rapidly, e.g., when central banks change interest rates, gold prices can swing violently.

Delivery Risk

When trading Futures or Forwards, remember that actual delivery of the goods must occur on the expiry date.

Summary and Application

Derivatives are neither inherently good nor bad. They are highly flexible tools that can make you wealthy or cause significant losses, depending on how you use them.

After reading this article, you should understand:

• ✓ What derivatives are and their types
• ✓ Which types are suitable for which situations
• ✓ The risks associated with derivatives
• ✓ How to maximize benefits from derivatives

Deep learning about derivatives and careful risk management are key to successfully using these tools.

Frequently Asked Questions

Q: Where can I buy or sell derivatives?
A: It depends on the type. Futures and Options are traded on official markets. Forwards and Swaps are negotiated privately. CFDs are traded via online trading platforms.

Q: Are Stock Options ###Equity Options### considered derivatives?
A: Yes, because their value depends on the underlying stock. They give the right to buy or sell stocks under specified conditions.