Understanding Derivatives: An Efficient Investment Tool Filled with Risks

In the modern investment world, investors have the ability to choose from a wide variety of financial instruments available, ranging from traditional investments such as direct asset purchases to derivatives, which are considered some of the most complex and high-risk financial tools. Although the risks are high, derivatives are widely used by investors for various purposes.

What are derivatives and how do they work?

Derivatives can be defined as financial contracts that establish an agreement between two parties regarding the price and quantity of an underlying asset, while the actual delivery or exchange of the asset occurs only at a future date agreed upon. The significance of these instruments lies in their ability to create opportunities for parties to lock in prices and quantities for actual delivery.

A clear example is when a trader enters into a futures contract to buy West Texas Intermediate crude oil at a price of $40 per barrel for delivery in late December 2020. This means that regardless of how market prices fluctuate, the actual delivery will always occur at the agreed-upon price. This provides both buyers and sellers with protection against price volatility.

Benefits investors can gain from derivatives

Price certainty

Using derivatives allows investors to set their desired prices in advance. Producers can be confident that there will be buyers and fixed prices in the future, while buyers will know they will receive the goods at the desired price and quantity.

Risk hedging in investment portfolios

Investors holding stocks or other assets can use derivatives to hedge against losses during periods of falling prices. For example, those holding physical gold can use futures or CFDs in a short position to offset potential losses.

Diversification of investment programs

Since derivatives do not require holding the actual underlying assets for trading, investors can access a variety of markets that may be difficult to access physically, such as oil, gold, and other commodities.

Price speculation

Certain types of derivatives are suitable for short-term speculation due to their high liquidity and ability to execute trades quickly.

Types of derivatives investors should know

1. Forwards(

A forward contract is a direct agreement between two parties, where the buyer and seller agree on a price today, but delivery and settlement occur at a future date. These contracts are often used to hedge price risks of agricultural products, commodities, and other goods. However, they have low liquidity and finding counterparties can be difficult.

) 2. Futures###

Futures are similar to forwards but are standardized and more regulated. The quantity, delivery date, and trading venue are clearly specified. Examples include West Texas Intermediate crude oil futures, Brent crude futures, and COMEX gold futures. Due to high standards, futures tend to have better liquidity.

( 3. Options)

Options give the right, ###not the obligation(, to the buyer to use or not use the right in the future. The buyer pays a premium, which is the cost of the option. The seller receives this premium but must be prepared to buy or sell the underlying asset as the buyer wishes. This instrument offers flexibility and helps investors limit risks effectively.

) 4. Swaps(

Swaps are agreements to exchange future cash flows between counterparties. For example, interest rate swaps allow companies to exchange fixed interest rates for floating rates, or vice versa. They play a key role in financial risk management but tend to have low liquidity.

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

CFDs differ from other contracts in that they do not involve the actual delivery of the underlying asset. Trading CFDs involves speculating on the price difference between opening and closing prices. Traders can go long or short. Leverage can amplify profits but also increases risks. CFDs are quite similar to TFEX contracts familiar to Thai traders.

Comparison of different types of derivatives

CFD is designed for profit from price differences. Its advantages include high leverage, the ability to amplify gains, low capital requirements, and high liquidity. It is suitable for short-term trading. However, high leverage can also magnify losses, making it unsuitable for long-term investments.

Forward contracts are used for hedging future commodity prices. Producers gain certainty about buyers and prices, but liquidity is low due to private negotiations, and there is a risk of having to deliver the actual commodity.

Futures offer formalized risk management features with high liquidity in exchange-traded markets. However, they also carry delivery risks. Standardized units are often large, making them less suitable for retail investors.

Options provide the right to buy or sell with limited risk (the premium paid) but potentially unlimited profit. They are versatile tools that can be applied in various strategies, though they require detailed understanding.

Swaps help hedge cash flow and interest rate risks but are less accessible to retail investors and tend to have low liquidity.

Risks associated with derivatives

( Leverage risk

Leverage )leverage### allows investors to use less capital, but incorrect predictions can lead to losses that are magnified proportionally. Managing risk through stop-loss orders and choosing brokers with margin protection systems is crucial.

( Delivery risk

Some contracts, such as futures and forwards, require the actual delivery of the underlying asset at maturity. Investors must understand the specific conditions of each instrument.

) Market volatility risk

Economic factors or market conditions can change rapidly, causing the underlying asset prices to move sharply. For example, interest rate adjustments can cause gold prices to fluctuate. Without proper risk management, significant losses can occur.

Summary

To truly understand derivatives, it is essential to recognize that they are double-edged tools. They can generate wealth or lead to substantial losses. Derivatives are like other power tools; experience and understanding of risks are critical. For knowledgeable and disciplined risk managers, derivatives can be valuable additions to investment strategies.

Frequently Asked Questions about derivatives

How risky are derivatives?

Risk depends on the type and how they are used. CFDs with high leverage carry higher risks than futures, while options may have lower risks depending on the strategy.

( Are futures suitable for beginners?

Futures require understanding of market mechanics and risk management. Beginners should learn the basics and understand the underlying assets before trading.

) Do options come with training or educational support?

Yes, options are complex, and buyers should study various strategies such as calls, puts, and their combinations before investing in real trading.