Basic knowledge about reference assets and their usage: Derivatives are modern financial instruments.

In today’s global financial markets, investors have access to a wider range of investment tools than ever before, whether through direct investment in underlying assets or via various fund channels. However, financial instruments such as (Derivatives) are considered among the most offering both significant opportunities and challenges. Many investors still do not fully understand what derivatives are and how to use them correctly. This article aims to provide an in-depth understanding so that investors can utilize these tools to manage risk and generate profit appropriately.

What Are Derivatives? Financial Instruments Linked to Underlying Assets

(Derivative) is a contract or agreement made today, based on the principle that there will be an exchange of goods or the right to buy or sell the underlying asset at a future date. The main feature of derivatives is that both buyers and sellers can agree on prices and quantities in advance, even if they do not hold the actual assets at that moment.

This operational characteristic means that the prices reflected in derivatives mirror market expectations of future asset prices. If, during the contract negotiation period until the delivery date, the market price of the asset changes, a price gap may occur, allowing investors to profit from these movements.

Practical Example: West Texas Crude Oil Futures Market

To clarify further, consider the case of West Texas crude oil futures contracts. Suppose in August, buyers and sellers agree that in December of the same year, the price of crude oil will be $40 per barrel. This agreement means that at the delivery date, regardless of the market price at that time, both parties will adhere to the $40 per barrel price.

For buyers, the advantage is certainty of obtaining the commodity at the predicted price, which is crucial for producers or consumers planning their finances. Sellers can be confident that their product will be purchased at a fair price, without worrying about falling market prices.

Types of Derivatives Based on Functionality

Since derivatives are used differently, they can be classified into several types based on their characteristics and contract conditions:

Forwards(: Direct Negotiation Contracts

These are agreements directly negotiated between two parties wishing to buy or sell an asset. Both agree on the price today but will deliver and settle the transaction in the future. Due to direct negotiation, these instruments tend to have low liquidity but are still popular for risk hedging, especially in agricultural and commodity sectors.

)Futures###: Standardized Contracts

Futures are similar to forwards but differ significantly in that all terms—such as quantity, duration, and conditions—are standardized and predetermined. This standardization allows trading on formal derivatives exchanges, such as crude oil futures markets or COMEX gold markets. The organized market structure results in higher liquidity compared to forwards, making futures suitable for speculation and hedging. However, the standard lot sizes are often large, making them less suitable for retail investors.

(Options): Rights with Choices

Options are contracts that give the holder the right, but not the obligation, to buy or sell an asset at a specified price in the future. The buyer pays a “premium” for this right, while the seller receives the premium but is obliged to fulfill the contract if the buyer exercises the option. Options are attractive because they limit the buyer’s maximum loss to the premium paid but offer unlimited profit potential.

###Swaps(: Cash Flow Exchanges

Swaps are agreements for exchanging future cash flows, often related to interest rates or currency flows, rather than underlying assets. They are advanced risk management tools, typically not traded on specific exchanges, resulting in relatively low liquidity.

)CFD (Contract for Difference)###: Speculative Instruments

CFDs differ greatly from the four types above. Traders do not own the actual asset but trade based on the “difference” between opening and closing prices. The advantage of CFDs is the high leverage (leverage ratio), allowing traders to control larger positions with less capital. They can also trade in both long ###rising prices( and short )falling prices( positions, making them suitable for short-term speculation. CFDs are similar to TFEX contracts familiar to many Thai traders.

Comparing Characteristics, Advantages, and Disadvantages of Different Derivative Types

Applying Derivatives in Portfolio Management

) Strategy 1: Lock in Future Returns

Derivatives are used to lock in prices and trading volumes in advance. Regardless of market price movements, investors can proceed based on the agreed prices. This is beneficial for producers and consumers seeking planning certainty.

( Strategy 2: Hedging Volatile Portfolios

During periods of market volatility, investors holding physical assets like real estate can use derivatives to hedge risks. For example, if holding gold and worried about falling prices, instead of selling and repurchasing )which incurs high fees(, investors can sell futures or CFDs in a short position to offset potential losses.

) Strategy 3: Diversifying Portfolios

Since derivatives do not require holding the actual assets, investors can easily access commodities like oil, gold, or other raw materials, enabling the creation of diversified portfolios efficiently.

Strategy 4: Capturing Price Differentials

Certain derivatives, especially CFDs, have high liquidity and are easy to trade. Traders can use them to profit from small price movements over short periods.

Risks and Considerations

Leverage Risk

Using leverage means that a small amount of capital can control a larger asset value, amplifying both gains and losses. If the market moves against the position, losses can exceed the initial investment. Proper risk management, such as setting stop-loss orders and choosing brokers with negative balance protection, is crucial.

( Delivery Risk

Some derivatives, especially futures and forwards, require actual delivery of the underlying asset at maturity. Investors must understand the specific conditions of each instrument before investing.

) Market Volatility Risk

Underlying asset prices can change rapidly, especially during major economic events, such as interest rate adjustments, causing significant price swings (e.g., gold prices). Without proper risk management, this volatility can lead to substantial losses.

Instrument Selection Risk

Choosing inappropriate derivatives can lead to unexpected outcomes. For example, selecting the wrong options type may result in losses rather than profits.

Frequently Asked Questions

Where are derivatives traded?

Depending on the type, most derivatives are traded on regulated exchanges or over-the-counter (OTC) markets ###OTC###, which are less regulated. For example, futures are typically traded on dedicated exchanges, while CFDs are often traded through online brokerage firms.

Are equity options considered derivatives?

Yes, equity options are fully classified as derivatives because their value depends on the underlying stock price. Buyers have the right to buy or sell the stock as per the contract, with value linked to the stock’s price movements.

Summary

For those seeking to understand what derivatives are, this article provides a comprehensive overview, including definitions, types, advantages, disadvantages, and usage methods. Derivatives are powerful tools that can build wealth or cause significant losses if used recklessly.

However, once investors understand the risks and benefits of derivatives, they can maximize their utility by adjusting risk levels to match their capabilities and investment goals with mindfulness.