From concept to application: An introductory understanding of derivatives

In an era where financial instruments are becoming increasingly diverse, investors must select tools that align with their goals and risk management capabilities. From gold bars to financial derivatives, investors have many options, whether through direct purchase, funds, or derivatives as one example. However, among all instruments, derivatives (Derivative) are considered the most renowned for their risk profile, yet they are also the least understood by most investors. This lack of understanding can lead to inappropriate decision-making.

To enable investors to utilize derivatives effectively and manage risks well, this article will reveal fundamental concepts and detailed applications of these tools.

What Are Derivatives in the Financial World?

Derivatives (Derivative) are not tangible assets but are contracts or financial agreements made between two parties today, agreeing to exchange an underlying asset (underlying asset) or to have the right to buy or sell an asset in the future.

The simple principle of derivatives is an agreement on quantity and price in advance. Both buyer and seller can be confident that in the future, they will be able to buy or sell the asset at the agreed price, regardless of market price fluctuations.

The importance of derivatives lies in their ability to reflect market outlooks on future prices. When market prices change between the contract date and the delivery date, opportunities for speculation and risk hedging arise.

###Real Market Example

Consider the situation in the West Texas crude oil market. In September, two traders agree on a futures contract for delivery in December at a price of $40 per barrel.

For the buyer: They gain confidence that they will acquire oil at $40 per barrel, even if market prices rise to $50 in December.

For the seller: They are assured that their product will have a buyer at a reasonable price, without worrying about falling prices during storage.

Both parties are protected upfront, and this is the core of derivatives – contracts between two parties that can manage risk.

Major Types of Derivatives

Derivatives come in various forms, each with unique features.

###Type 1: Forwards(

Forward contracts are agreements between two parties to buy or sell an asset at an agreed-upon price and quantity today, with delivery and settlement occurring in the future.

Advantages:

• Highly customizable to the trader’s needs
• Actual delivery of the asset occurs

Disadvantages:

• Low liquidity due to private agreements
• Not suitable for short-term speculation
• Commonly used in agriculture and commodities

)Type 2: Futures###

Futures contracts are similar to forwards but have strict standardization.

Features:

• Same standards: quantity, quality, and delivery date
• Traded on official exchanges
• High liquidity
• Examples: crude oil, Brent oil, gold on COMEX

Benefits:

• Can be traded long or short as desired
• Positions can be closed before delivery to avoid actual transfer

Drawbacks:

• Fees for closing positions
• Standard units may be large for retail investors

(Type 3: Options) – Rights, Not Obligations

Options give the holder the right ###not mandatory( to buy or sell an underlying asset at an agreed price in the future.

Mechanism:

• Buyers pay a “premium” for the right
• Sellers )Option writers( receive the premium and are obliged to fulfill the contract if exercised

Advantages:

• Limits risk to the premium paid
• Unlimited profit potential
• Highly flexible

Disadvantages:

• Complex; requires detailed understanding
• Misuse can increase risk

)Type 4: Swaps(

Swaps are agreements to exchange future cash flows, differing from other instruments.

Benefits:

• Hedge against interest rate risk
• Manage cash flows efficiently

Drawbacks:

• Low liquidity
• Usually for institutional investors only

)Type 5: Contracts for Difference ###CFD(

CFDs differ clearly from the first four types: no actual delivery of goods.

Key features:

• Based on futures or other assets
• Settled as the difference between opening and closing prices
• Profitable in both rising and falling markets
• Use leverage to amplify gains
• Similar to the TFEX contracts familiar in Thailand

Advantages:

• High leverage enhances profit potential
• Low capital requirement
• High liquidity
• Easy to trade via apps
• Can profit from both upward and downward movements

Disadvantages:

• High leverage also amplifies losses
• Not suitable for long-term investing

Summary Comparison Table

Benefits of Using Derivatives in Investment

) 1. Lock in returns and prices

Derivatives allow investors to agree on prices and quantities in advance. This certainty reduces worries about market volatility.

2. Hedge investment portfolios

Futures and CFDs are highly liquid. Investors can take short positions to avoid selling physical assets (such as gold), which may incur high fees.

Example: Gold holders during a price decline can sell futures to offset losses.

3. Diversify portfolios

Derivatives open access to other heavy assets like oil and gold without the need for physical transportation or storage.

4. Speculate on price changes

Traders can efficiently use CFDs to profit from price differences, benefiting from liquidity and easy access.

Risks to Consider

( Leverage risk

Leverage can significantly amplify gains, but also losses. If prices move against the position, losses can exceed the initial investment. To manage this:

• Choose brokers with Negative Balance Protection )Negative Balance Protection###
• Regularly set Stop Loss and Trailing Stops
• Avoid excessive leverage beyond manageable levels

Delivery risk

Some instruments ###Forward, Futures( may require actual delivery. Investors should study each instrument’s conditions carefully.

) Market volatility risk

External factors ###such as interest rate adjustments, economic data, political events( can cause sudden price swings.

Example: Announcements of interest rate changes can cause gold prices to fluctuate sharply. Investors without hedging may suffer losses.

Conclusion

Derivatives are powerful tools with many benefits but also high risks. The fact that they can make you wealthy or cause losses is due to their flexibility and immense potential.

The key to effective use of derivatives is:

1. Understanding the tools: Study the characteristics of each type
2. Managing risks: Use Stop Loss, Trailing Stops, and avoid excessive leverage
3. Having a plan: Set clear goals and follow them strictly

With knowledge and good management, investors can leverage derivatives to enhance returns and protect their portfolios from risks appropriately.

Frequently Asked Questions

) Where are derivatives sold?

Depending on the type, some ###futures( are traded on official exchanges, while others may be sold in less regulated markets or OTC markets.

) Are equity options ###Equity Option( considered derivatives?

Yes, equity options are contracts referencing stock values. Their value depends on the underlying stock price, making them derivatives by our definition.