why derivatives are dangerous?

Replies to This Discussion

Permalink Reply by Kaustubh Shrotriya on January 18, 2010 at 4:15am

This can be explained with a simple example... Let us suppose you have $100. and you want to buy a stock the price of which is $100. So in a spot market (cash market) you an buy one share of that stock...let us suppose that the call option on that stock is available in the derivatives market for $10 with a strike price of $100. So you can buy 10 call options on that stock in the derivatives market.

Say after a month the price of the stock is $110. in cash market you make a profit of $10 by selling the one share of stock that you are holding ($110 - $ 100).

In the derivatives market you make a profit of $100 [($110-$100) * 10]........

Adversely if the stock price would have fallen to $90 after a month, you would have incurred a loss of $10 in the spot market (100-90)..whereas in the derivatives market you would not have excercised the call option since the market price would have been lower than the strike price....you would have made a loss of $100 (premium per share * no of shares)...............

Investment made was $ 100 in both casses but you made much larger profit / loss in the derivatives market...
In derivatives market you can trade a larger quantity of securities by paying a small amount of premium...So the profit / loss that you make is in multiple as compared to the trades you make in the cash (spot) market.........Hope this makes it clear..........

▶ Reply to This

Permalink Reply by Kamesh Kumar on February 13, 2010 at 12:05pm

It is just like an intraday trading in which if you have 10 rupees so you can buy the shares of 100 rupees if your limit is 10 times. So if the stock price will increase by 10% you will get a profit of 10 rupees and vice-versa.

▶ Reply to This

Permalink Reply by Kamesh Kumar on February 13, 2010 at 12:06pm

I increases your risk as well as your return so be careful in the case of derivatives.

▶ Reply to This

Permalink Reply by Chad Ellis on January 18, 2010 at 9:21am

Many derivative positions can be created by combinations of buying the underlying security with borrowed money. The resulting effect is that just like buying and asset on margin (or selling it short), you magnify your exposure to moves in the underlying security.

Let's build on Kaustubh's example. Suppose that instead of just buying a call with a strike price of $100, you also sold/wrote a put with the same strike price. For the same of simplicity, let's assume that the put and call have the same price in the market and that you're asked to put up margin of $20 for the put.

Now you've got the same exposure to changes in the share price as if you'd bought the stock directly, but you've only tied up $20 of your own capital. That's equivalent to having bought the stock directly but using 80% borrowed funds to do so.

▶ Reply to This

Permalink Reply by Hassan Ali on January 18, 2010 at 9:29am

In order to answer your question let me first describe what a derivative is, as per IAS 39,

A derivative is a financial instrument:

Whose value changes in response to the change in an underlying variable
That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and
That is settled at a future date. [IAS 39.9]


An underlying can be commodity or security price, or index;

From this definition it is clear that a a derivative has no value of its own but depends on value of the underyling variable.

Risk relating to a derivative linked to say a stock exchange index and an asset with leverage is similar because both depend on the interest rates. An increase in interest rate will increase the finance cost of a leveraged asset hence bring down its value, similar impact is also witnessed on the companies listed on the stock exchange assuming that borrowings are being done at variable rates.

Hope this explains your query in a simple way.

▶ Reply to This

Permalink Reply by Brice MacGregor on January 18, 2010 at 10:28am

There are a lot of reasons that people consider derivatives dangerous and entire books on the topic. The reason most related to your question relates to embedded leverage in the instruments themselves. In many markets, participants must only post a small fraction of the value of the underlying asset as collatoral to take a position. For example, say I think the price of stock A is going to go up and I have enough cash to buy 1,000 shares outright. However, suppose I go to a futures exchange instead and there I only have to post collatoral worth 10% of the underlying asset, I could then go long with a futures contract on 10,000 shares. This is effectively the same things as borrowing to buy the asset outright.

Note that there are many other reasons why derivatives are considered dangerous. First, the payoffs from derivatives, options in particular, are often more complicated than is the case for the underlying asset. This combined with leverage can expose a non-sophisticated investor to more risk than they bargained for. Second, there is a massive over-the-counter derivatives market which can be very opaque. The opacity of the market conceals issues such as the systemic risk to the financial system that can build up when you have a small number of key counterparties. When one of them goes bankrupt, market participants don't know where all the landmines are in terms of exposure to these key counterparties and markets freeze up. This is what happened when Lehman and AIG went bankrupt.

All that said, derivatives obviously provide benefits in terms of allowing people to hedge or speculated on risk adding to market liquidity and price formation. However, clearly investors need to be better informed about these products. Moreover, increased market transparency would be helpful at addressing the buildup of systemic risks.

I hope you find that useful.
Cheers,
B

▶ Reply to This

Permalink Reply by Jackson on January 18, 2010 at 10:00pm

I think depends at what angle you see derivatives. I personally believe that buying assets with leverage can be riskier than buying options. There is a chance that buying assets with leverage can get you into negative equity status (or margin calls) if you are wrong in the direction. On the other hand, the maximum loss on options is all the premium you invested.

▶ Reply to This

Permalink Reply by Wayne Jooste on March 16, 2010 at 1:56am

Just a quick reply to the comment "derivatives are dangerous". Whilst I agree that derivatives are dangerous I feel that this is only true when used by for examples traders that do not understand the asset class entirely and then of course there are the speculators. I feel the only speculators would consider dervatives to be of equal standing to leveraged assets as they would be trying to forecast a movement in the underlying asset and bet on that movement whilst applying a much smaller amount of capital to participate in this forecasted movement.

On the other hand there are managers like myself that utilise dervatives as a means in reducing risk in a share portfolio by giving a a small percentage of the upside to protect on the downside. If anything has to be learnt from thiscurrent market crash it is this fact - The upside in a portfolio takes care of itself whilst the downside needs to be managed.

Make sure that you have an excellent knowledge of derivatives before you start using them in portfolios and they will soon become your best friend.

▶ Reply to This