Speculative tools that make people rich or bankrupt: An explanation of derivatives

Have you heard about trading oil, gold, or stocks without actually owning the physical asset? That’s the marvel of derivatives—the most flexible financial instruments in today’s market. But they are also full of risks that can make traders either very wealthy or completely broke. This time, we will thoroughly understand derivatives.

What are derivatives? They are not just simple speculation

Many people confuse derivatives (Derivative) as simply making money out of thin air. In fact, they are financial instruments created from agreements or contracts between buyers and sellers today, setting the price and quantity of the asset to be traded in the future.

The special feature of derivatives is that both parties can agree on the price right now, even if they do not hold the asset yet. When the delivery date arrives, if the asset’s price has changed from the agreed price, the difference will be settled. This is where traders aim to profit from price movements.

Real example: Suppose a December 2020 West Texas crude oil futures contract is agreed at $40 per barrel. The seller is confident they can sell oil at a stable price, and the buyer is confident they will receive the product at the agreed price. If at delivery the oil closes at $50, the buyer gains a $10 profit per barrel.

5 Types of derivatives every trader should know

1. Forwards (Forward Contracts): Customized agreements

Forward contracts are direct agreements between two parties, agreeing on price and quantity today, but delivery occurs in the future. The downside is low liquidity because there is no centralized market. They are more suitable for producers of agricultural goods who want to hedge prices rather than for speculation.

2. Futures (Futures Contracts): The standardized version of Forwards

Futures are standardized forward contracts traded on centralized exchanges. They have fixed trading units, making them highly liquid. Common examples include NYMEX (oil), COMEX (gold), Chicago Mercantile Exchange, etc. Traders can close their positions before the delivery date to avoid actual delivery.

3. Options (Options Contracts): Contracts with choices

Options differ because buyers pay a “premium” for the right, but not the obligation, to buy or sell in the future. Sellers receive the premium immediately but must fulfill the contract if the buyer exercises the option. Options are flexible because losses are limited, but profits can be unlimited.

4. Swap (Interest Rate Swap): Cash flow exchange tools

Swaps are agreements to exchange future cash flows or interest rates. For example, a company might swap floating interest rates for fixed rates to improve financial planning. Financial institutions prefer swaps over individual traders.

5. CFD (Contract for Difference): Modern speculative tools

CFD differs significantly from the four above. No physical delivery occurs; instead, it involves trading contracts that track the price of futures or other underlying assets. When closing a position, only the price difference is settled.

Advantages: Low capital requirement due to high leverage, high liquidity, ability to trade both rising and falling markets, accessible via apps anytime anywhere. Disadvantages: High leverage amplifies both gains and losses, not suitable for long-term trading.

Comparing the 5 types: pros, cons, and usage

What are derivatives used for? 4 practical applications

1. Lock in prices to predict the future

Oil producers can use Futures to lock in future selling prices, avoiding worries about price drops. Buyers can also lock in prices, serving as real risk insurance.

2. Hedge portfolio risks

An investor holding 1 kilogram of gold worries about falling prices. Instead of selling and paying fees, they can sell Gold Futures or CFDs to hedge. If gold prices fall, losses on physical gold are offset by gains from futures sold.

( 3. Diversify portfolios by investing in non-physical assets

Ordinary people usually cannot hold many tons of oil or gold, but through Futures or CFDs, they can open positions and expand their portfolios.

) 4. Speculate on price movements ###Speculation###

This is what makes people rich or broke. Traders use CFDs or Futures to predict price directions. If correct, they profit from the difference; if wrong, they lose.

Risks: Why derivatives are double-edged swords

( 1. Leverage = Double-edged sword

Derivatives like CFDs and Futures often have high leverage )10x, 50x, 100x###, meaning with $1, you can control assets worth $10-$100. If prices go up 1%, you gain 10-100%; if they go down 1%, you lose 10-100%. Without caution, your money can vanish instantly.

( 2. Market volatility risk )Market Volatility Risk###

Prices can move violently, such as during interest rate announcements, causing spikes in gold or currency prices. Traders with excessive long (Long) positions may be liquidated (completely) immediately.

( 3. Delivery risk

Some Futures contracts require actual delivery. Traders must understand delivery periods and conditions well; otherwise, they may face delivery issues.

) 4. Counterparty risk

Forwards are bilateral agreements; if the counterparty defaults, you risk not getting paid. Futures traded on centralized exchanges have lower risk.

Trader advice: How to manage risks

1. Choose a good broker with Negative Balance Protection ###so you won’t lose more than your deposit###.
2. Set Stop Loss immediately, not later, to limit losses.
3. Use appropriate leverage, not always the maximum.
4. Understand the contract thoroughly before buying or selling; read all conditions.
5. Trade with money you can afford to lose, not gambling money.

Summary: Derivatives are neither good nor bad

Derivatives are tools—like knives or guns. Used well, they save lives; used poorly, they can kill. By deeply understanding price forecasting, leverage, risks, and risk management, derivatives like CFDs, Futures, and Options can be powerful channels for profit or hedging.

The bottom line is to study extensively, manage risks well, avoid reckless moves, and remember that most wealthy traders in derivatives are not necessarily the most talented, but those who are patient, educated, and disciplined.