Is it Safe to Invest in Financial Derivatives

The mere mention of financial derivatives brings a lot of divided opinion in the financial sector. There are those who feel financial derivatives are reckless instruments. The basis is that speculation fuels the trade, and if left unchecked this is likely to create a lot of pandemonium not just in the financial sector, but the world economy as a whole. Warren Buffett expressed his concern with derivatives and termed them “weapons of mass destruction“. On the other hand the other group which is in support of financial derivatives believe they have changed the face of the financial world by creating new ways of understanding and managing risk in the financial world.

Financial derivatives are contracts that are based or derived from some underlying asset reference rate or index. While new forms of derivatives are entering the market there are four main groups which are as follows: swaps, forwards, futures and options based on interest rates or exchange rate. All these financial instruments work in different ways.

The call option allows one to purchase a stock at a specified price before a set deadline period, while the put option allows one to sell a stock at an agreed price with a deadline date. Futures contracts are an agreement to sell or buy assets at an agreed time. Most future contracts are in commodity trading. Forward contracts also function the same way as future contracts except that future contracts are not traded on the formal market. A swap is a forward derivative that obligates two parties to exchange a series of cash flows at an agreed time.

The website Daily Finance illustrates how popular financial derivatives are worldwide. It is estimated this market is worth $1.2 quadrillion worldwide and is largely unregulated. The question that deserves to be answered is how safe it is to invest your money in this type of market. Mention of derivatives is likely to frighten most retail investors for it strikes a lot of bad memories about the American company Enron which collapsed.

The misuse of derivatives played a major role in the collapse of one of the largest bankruptcies in the United States history. This is one big problem of this market; there is just so much bad publicity in the press. Stories tend to focus on the collapse and illegal use of derivatives rather than how much it is really worth. The mere fact that the derivative market has been growing shows that there is profit being made daily. One perception that most retail investors have is that the derivative market is just so complicated making it a difficult sector to invest your money.

To have success in the derivative market one must use a number of strategies to make profit. For a typical retail inventor this is just too much as it might require one to use sophisticated technological driven solutions. To make matters worse unlike the various stock exchanges that have a lot brokers and advisory services the derivative market lacks such resources making it dangerous for one to invest. There is a need for seminars and other printed material for the purpose of investor education. If one can have such resources then derivatives investing become less risky and one can get the experience of trading in this complex market.

The derivative market is mostly an institutional market. It suits the institutions because many have the necessary resources and have the ability to absorb losses if something goes wrong. With enough resources this market can offer one a chance of “gearing” which means the ability of derivatives to soar in a few days and make massive profits. An investor can take a position that the housing market will shoot in the near future while investing a nominal figure of $10,000 and borrowing $100,000 the house can be purchased. If the price of the house rises to $150,000 that means the profit made is $40,000. This is a good return for the money.

The opposite though can happen and the market might collapse and the house fall to $80,000. This now puts the investor under pressure because they have lost $30,000. This is what makes trading with derivatives risky. So for a retail investor who has limited knowledge about the specific market, it will be close to speculation. So when financial derivatives are used without a plan, they can inflict pain by causing serious losses. When used properly, financial derivatives can help organizations to meet their risk-management objectives so that funds are available for making worthwhile investments.

In conclusion the derivative market is not uniform and is vast so a “one size fits all“ approach will not work. It is of vital importance  to understand the contracts and the accompanying risk taken before one trades with derivatives. It is also crucial that traders do not take a lot of unnecessary risks when trading. Investing in these financial instruments comes down to the level of suitability. If one is going to invest in financial derivatives they have to know what they are getting into. You have to be the right investor for the market.