Understanding Derivative Instruments of Investment Products: From Basic Knowledge to Practical Operations

For investors, there are a variety of investment products available in the financial markets. In addition to traditional stocks, forex, commodities, and indices, derivative instruments offer a whole new dimension for investment. This article will delve into the nature, types, risks, and opportunities of derivative financial products to help investors build a comprehensive understanding framework.

Definition and Core Features of Derivative Financial Products

Derivatives are a special class of financial instruments whose value derives from the price performance of underlying assets. These underlying assets may include stocks, bonds, commodities, indices, or interest rates. In simple terms, derivatives are tradeable financial contracts that track the market fluctuations of the underlying assets.

The three core advantages of derivatives

High Leverage Effect: Investors only need to deposit a small margin to control assets of equivalent value. This mechanism significantly lowers the entry barrier but also amplifies risks and returns.

Two-way Trading Flexibility: Unlike traditional investment products, derivatives allow investors to go long and short, providing profit opportunities whether the market rises or falls.

Hedging Function: Many companies and institutions use derivatives to hedge against exchange rate risks, price volatility, and interest rate risks, making this one of the most practical applications of derivatives.

Why Do Investors Choose Derivative Financial Products?

Three Main Investment Purposes

Speculation: Traders predict asset price changes and leverage to amplify returns. Due to the high volatility of derivatives, short-term profit opportunities are relatively abundant.

Hedging: Companies or investors perform opposite operations to protect existing assets. For example, an investor holding stocks can buy related put options to offset losses when stock prices fall.

Arbitrage Strategies: Exploit price differences between different markets or contracts to obtain risk-free or low-risk returns. A typical example is arbitrage between upstream and downstream in the futures market—when iron ore prices fall, it is expected that steel prices will also decline, prompting corresponding trading adjustments.

Classification System of Derivative Financial Products

The common derivative products in the market are mainly divided into five categories, each with its own characteristics:

① Futures Contracts

Futures give traders an obligation (not an option) to buy or sell an asset at a specified price on a future date.

Features:

• Standardized Design: Contract specifications, trading volume, and settlement times are uniformly regulated by exchanges, facilitating centralized bidding and liquidity management.
• Leverage Mechanism: Investors can control larger assets by paying a margin.
• Mandatory Settlement Rules: Contracts must be closed or settled before expiration; individual investors usually settle in cash.

Important Reminder: Futures margins increase as the contract approaches expiration. If investors do not close their positions before expiry, the futures broker will forcibly close at market price, which poses higher risks for inexperienced investors.

② Options

Options give the buyer the right (not obligation) to buy or sell an asset at an agreed price on a future date, offering greater trading flexibility.

Features:

• Standardized Contracts: Specify underlying assets, strike prices, expiration dates, etc.
• Multi-layered Strategies: Include call options (expecting price rise) and put options (expecting price fall), which can be combined.
• Time Decay: The value of options accelerates in depreciation as expiration approaches; most options expire worthless.

Risk Warning: Options trading is complex and requires substantial professional knowledge. Time decay means investors must realize profits before expiration; otherwise, the principal may be lost entirely.

③ Contract for Difference (CFD)

CFD represents an agreement between traders and brokers, where profits or losses depend on the difference in the underlying asset’s price at opening and closing. Investors do not actually own the underlying asset.

Features:

• Non-standardized: Over-the-counter (OTC) trading, with flexible contract specifications suitable for various strategies.
• High Leverage: Investors only need to pay a margin of 1%-10% of the contract value.
• No Expiry Date: In theory, positions can be held indefinitely, offering more trading flexibility.

Risk Considerations: Since trading occurs OTC, choosing a regulated and reputable platform is crucial. Some assets’ CFDs may have low liquidity, leading to price slippage and widened spreads.

( ④ Forward Contracts

Forwards are private agreements between two parties to trade an asset at a predetermined price at a future date, without involving intermediaries.

Features:

• Fully Customizable: Contract terms are negotiated based on needs, including underlying assets, delivery date, and price.
• Long-term Nature: Often used for long-term investment or risk management.
• Counterparty Risk: Since trading occurs in non-public markets, there is a risk of counterparty default.

) ⑤ Swaps

Swaps are contracts where parties agree to exchange future cash flows. Common types include interest rate swaps, currency swaps, commodity swaps, and equity swaps.

Features:

• Highly Customizable: Fully negotiated according to the needs of both parties.
• High Complexity: Usually involve legal documentation, accounting treatment, and regulatory compliance.
• Institutional Use: Mainly used by financial institutions rather than individual investors.

Core Differences Between Derivative Financial Products and Investment Products

Traditional investment products (like stocks) are traded on centralized exchanges under uniform regulation. Derivative products, due to their complex structures and strategies, have different features:

Risk Assessment of Derivative Financial Products

Main Risk Factors

High Volatility Risk: The complex design of derivatives leads to sharp price fluctuations, making extreme valuations unpredictable.

Leverage Risk: While leverage increases potential gains, it also magnifies losses. Adverse market movements can lead to margin calls and forced liquidation.

Liquidity Risk: Some derivative markets have low liquidity, which may cause slippage or difficulty in executing trades promptly.

Counterparty Risk: OTC trading involves the risk that the counterparty may default, resulting in direct losses.

Time Decay Risk: Especially relevant for options and other time-limited derivatives, their value diminishes over time.

Risk Management Recommendations

Choose regulated, reputable trading platforms; thoroughly understand derivative mechanisms; set clear stop-loss and take-profit levels; avoid excessive leverage; continuously monitor positions.

Advantages and Disadvantages of Derivative Financial Products

Advantages

• Superior Market Liquidity: Multiple trading channels provide ample trading opportunities.
• Cost-Effectiveness: Transaction fees are usually lower than underlying assets.
• Strong Hedging Capabilities: Effectively hedge against exchange rate, interest rate, and price risks.
• High Capital Efficiency: Margin mechanisms improve capital utilization.

Disadvantages

• Complex Rules: Require investors to have professional knowledge and experience.
• Higher Risks: Losses can exceed initial investments.
• Counterparty Risk: OTC transactions carry credit risk.
• Time Sensitivity: Some derivatives are sensitive to timing and require active management.

Who Is Suitable for Participating in Derivative Trading?

Typical Participants

Commodity Producers and Miners: Use futures to lock in prices and hedge against price fluctuations.

Hedge Funds and Asset Management Firms: Use derivatives for portfolio hedging or leverage.

Traders and Individual Investors: Engage in short-term speculation and leverage to quickly increase profits.

Financial Institutions: Conduct complex arbitrage and risk management operations.

Trading Channels for Derivative Financial Products

Traditional Exchange Trading

Brokerages and futures firms typically offer exchange-listed derivative contracts, which are strictly regulated with complex trading rules and relatively more restrictions.

OTC Markets###OTC###

OTC trading refers to transactions directly between two parties without third-party involvement. These contracts are non-standardized, with fewer restrictions, but carry counterparty risk. Derivatives such as futures, options, and CFDs can be traded OTC.

( Different Investment Products and Trading Options

Different types of derivatives have different trading channels. Investors should select suitable product types and trading platforms based on their investment goals, risk tolerance, and market understanding. Before trading, it is essential to fully understand the associated risks and develop a clear trading plan.

Comparison of Derivative Financial Products and Stock Trading Applications

The fundamental difference between derivatives and stocks lies in their purpose. Traditional stock investing focuses on asset allocation and long-term holding, while derivatives are mainly used for hedging, arbitrage, and speculation. The high leverage of derivatives makes them suitable for short-term trading, requiring investors to have higher professional skills and risk awareness.

In summary, derivative financial products offer greater flexibility and more strategic options compared to traditional investment products. However, as high returns are accompanied by high risks, investors should carefully assess their capabilities and establish comprehensive risk management systems when utilizing derivatives.