What is derivatives and how to trade derivatives to make a profit? Detailed guide [Real-life example]

This article will help you understand: what derivative instruments are, the most common types of derivatives, how to trade derivatives to make money, and the risks to watch out for when trading.

Derivative Instruments (Derivative) - From Past to Present

Derivative securities are not a new concept. As early as the second century BC in Mesopotamia, humans created primitive futures contracts. However, this tool only truly developed in the 1970s with the advent of modern pricing techniques. Today, the global financial system cannot function without derivatives.

What Are Derivatives - Definition and Operating Mechanism

A derivative (derivative) is a financial asset whose value depends entirely on the fluctuations of the underlying asset. The underlying asset can be:

• Commodities: crude oil, gold, silver, agricultural products
• Financial assets: stocks, bonds, stock indices
• Other factors: interest rates, foreign exchange rates

When the price of the underlying asset changes, the value of the derivative also changes accordingly. This makes derivative valuation more complex than traditional financial assets.

Main Types of Derivative Instruments

The derivatives market includes 4 main types of contracts:

1. Forward Contract (Forward)

• Two parties agree to buy and sell an asset at a predetermined price, with the transaction executed at a future date
• No third-party intervention
• No margin required

2. Futures Contract (Future)

• A standardized version of the forward contract
• Listed and traded on official stock exchanges
• Prices are updated daily based on market value
• Margin must be posted at the exchange

3. Options (Option)

• Allow the holder the right, (not obligation), to buy or sell the underlying asset at a predetermined price
• The most modern derivative instrument listed on exchanges
• Price influenced by many factors and requires complex formulas for valuation

4. Swap (Swap)

• Exchange between two parties involving buying and selling transactions
• Cash flows are calculated based on specific principles
• Usually traded over-the-counter (OTC)

Two Ways to Trade Derivatives

Method 1: OTC Trading (Unregulated)

• Contracts are privately negotiated between two parties
• Not regulated by the government
• Lower costs due to lack of intermediaries
• Risk: the counterparty may default at maturity

Method 2: Exchange-Traded Trading ###Regulated(

• Contracts must undergo approval before listing
• Supervised by the government
• Higher fees but better protection of rights

The Most Popular Derivative Tools

) CFD ###Contract for Difference( CFD is an agreement between an investor and a broker, where the buyer receives the price difference of the asset between opening and closing the position.

Features of CFD:

• No expiration date — can close the position at any time
• Applicable to over 3000 types of commodities
• High leverage allows for low initial capital
• Low trading costs
• Price closely tracks the underlying asset

) Options (Option) Provide the right, (not obligation), to buy or sell an asset at a specified price within a certain period.

Features of options:

• Limited time — positions can only be closed before or on the expiration date
• Regulated, so not all commodities have options contracts
• Large trading volume, higher fees than CFDs
• Price requires complex formulas for calculation

How to Trade Derivatives

To start trading derivatives, investors should follow these steps:

Step 1: Choose a reputable trading platform Select a licensed platform with a good reputation to avoid risks of counterparty default.

Step 2: Open a trading account Register on the chosen platform and complete the necessary verification procedures.

Step 3: Deposit initial margin The margin amount depends on the number of assets you wish to trade and the leverage used.

Step 4: Execute buy/sell trades Based on market predictions, investors place Long (predicting price increase) or Short (predicting price decrease) orders via app or web.

Step 5: Manage positions Monitor open positions, set take profit (take profit) and stop loss (stop loss) orders appropriately.

Real-Life Example: Trading Derivatives for Profit

Suppose you predict gold prices will fall soon. Currently, gold is at $1,683/oz. You do not own gold but want to profit from price movements, so you use a CFD on gold.

Open a Short position: You open a sell (Short) order at $1,683/oz. When the price drops to $1,660/oz as predicted, you close the position at a lower price, earning $23/oz.

Using 1:30 leverage: Instead of paying $1,683 for 1 oz of gold, you only need $56.1 $23 30 times less$23 . When the price drops $23, your profit is:

• With 1:30 leverage: profit $17 = profit 41% of initial capital $56.1
• Without leverage: profit $17 = profit 1.36% of capital $1,683

Similarly, if gold rises to $1,700 and you close at a loss:

• With 1:30 leverage: loss (= 30%
• Without leverage: loss )= 1%

This illustrates the benefit of leverage — increasing profits but also proportionally increasing risks.

Why Trading Derivatives Is Attractive

Derivatives are widely traded in many countries because of the benefits they offer:

Hedging risk: Investors can buy derivatives that move inversely to their owned assets, offsetting potential losses.

Asset valuation: The spot price of futures contracts helps determine the true value of the underlying commodity.

Market efficiency: Using derivatives helps replicate the payout profiles of assets, balancing the prices of the underlying and derivative.

Access to intangible assets: Through interest rate swaps, companies can obtain more favorable interest rates than direct borrowing.

Risks of Trading Derivatives

Like any financial product, trading derivatives involves significant risks:

High price volatility: The complex design of contracts makes valuation extremely difficult and sometimes unpredictable. High risk is inherent in derivatives.

Speculative tools: Due to their risky and volatile nature, derivative prices are unpredictable. Speculative trading without proper understanding can lead to large losses.

Counterparty risk OTC: If trading on decentralized platforms, the counterparty may default.

Pricing risk: Options require complex formulas for valuation, and inexperienced investors may misprice contracts.

Who Should Trade Derivatives

Derivatives are suitable for the following groups:

Commodity producers: Companies extracting oil, gold, or other commodities can use derivatives to lock in prices and hedge against volatility.

Portfolio management funds: Hedge funds and trading firms use derivatives to manage risk or enhance portfolio returns.

Traders and individual investors: Use derivatives to speculate on asset movements, often employing leverage to increase potential profits.

However, beginners should thoroughly understand the tools before participating, as derivatives are complex and high-risk instruments.