Trading Derivatives Is Risky

Here Are the Risks Traders Must Know

Warren Buffet, a famous investor, once referred to derivatives as financial weapons of mass destruction. Interestingly back in 1982 he wrote to Congressman John Dingell discouraging the congress from approving the use of derivatives. Congress went ahead to approve derivatives and the rest is history.

This leads us to ask: are derivatives that harmful? Warren Buffet says there’s nothing wrong with derivatives themselves, but says that the problem is that they encourage leverage which is borrowing funds from your broker to trade, similar to funded trading.

That being said, a derivative is basically a financial contract that owes its existence to an underlying asset. It is always tethered to an asset. Some derivatives like options and futures are exchange traded while others like CFDs and forward contracts are traded over the counter (OTC).

However, it should be noted that trading derivative comes with great risk. Incessant market volatility could put you at great risk and uncertainties.

These risks and uncertainties have recently been fueled by hikes in interest rates, conflict in Ukraine that many experts on economics now fear could lead to global recession or economic downturn.

Ideal for Hedging Risk

Derivatives are ideal for hedging risk. When an asset is affected by high volatility, investors might resolve to hedge their risk through future or options trading. The intention is to reduce the risk that accompanies unfavorable price movement.

Firstly when you enter into a futures contract with a counterparty, you have the right to buy from or sell a specific quantity of the underlying asset to the counterparty, at a specific price and at an agreed future date.

Upon expiry, futures contracts can be settled in cash or via physical delivery of the underlying asset. Businessmen who enter futures contracts may opt for physical delivery of the goods and investors may opt to take delivery of the shares.

If you fear that TSLA shares will lose value one month from now, you can enter a futures contract to guarantee that you sell a specific quantity of your TSLA shares at today’s price, one month from now. By doing that you have hedged the market risk.

Secondly, an options contract gives you the right but not the obligation to buy or sell a specific quantity of the underlying asset, at a specified strike price and at a future date. A contract that gives you the right to buy from is a ‘call option’ and a right to sell to is a ‘put option’.

To buy an option from the option writer, you pay him a ‘premium’. Upon expiry of an option contract & because of the obligation clause, you can chose not to exercise the option and walk away but you forgo the premium.

This lack of obligation is a major difference between options & futures. One option contract contains 100 shares of the underlying.

Propensity for abuse

In Warren Buffet’s 1982 letter to Congressman John Dingell , he warned that making it easy to trade derivatives will lead people into gambling and speculating instead of true investing. We see this today as many traders now trade derivatives for the thrill and for a quick buck not minding the risks.

While trading option contracts, it is possible to lose your entire principal capital and sometimes even more. Option premium has no fixed size or price. However, it could be influenced by three main factors which include the price of the underlying asset, its level of volatility and the option’s time of expiration

Remember that options are traded on an exchange and their prices are determined by demand and supply. The closer the option is to its expiry date, the lower the price falls and you will find it hard to sell since you are a trader who trades options for profit. This is the concept of time decay of an option. You end up forgoing your premium and this is a loss for you.

Furthermore, if you are a writer of a call option, you will be at great risk. A call option writer otherwise known as a guarantor formulates a contract and set a specified price and date.

The writer of a call option will be forced to sell the asset at the strike price to the option holder on the expiration date, even if the price rises above the strike price which means selling at a great loss.

This is because the call option holder takes a long position with limited downside risk, while a call option writer takes a short position with unlimited exposure to risk.

The fortunes of the call writer and the option buyer move in the exact opposite direction. If the option buyer earns a profit, the call writer will suffer a loss and vice versa

Futures trading requires a higher degree of skills because of the risk involved. Future trading is more dangerous because the contract specifications are more complex than trading shares or currency.

For instance, on the Chicago mercantile exchange the following applies

As can be seen in the table above, futures contract sizes carry a lot of weight. Unlike in CFD trading where one CFD represents one unit of the underlying asset, you can see that one Chicago wheat futures contract equates to 5,000 bushels.

For Chicago wheat futures, if the price of the futures contract moves from say 4.0025 to 4.000 the difference is 0.0025, which is one tick as per CME rules. This means you lose (5,000 bushels x 0.0025) = $12.5

If the market keeps moving against you, heavy losses could be incurred thus blowing your trading account.

Furthermore, mark to market compels you to pay for any price change in the underlying asset. This payment is made daily so that if you choose to default or run away, your broker will only be liable for only one day’s market move payment. This can cause a margin call which could lead to liquidation if not attended to.

Trading future requires you to deposit an initial margin and also maintain a certain margin level to keep your position. If your margin is low, you can be closed out of your trade position.

In most cases, the maintenance margin is typically between 50 to 75%. The maintenance margin is sometimes otherwise known as the variation margin. Trading future can be very dangerous because of the use of leverage which multiplies your profit and loss.

Contract for difference (CFD) allows you to speculate and to trade both directions of the price movement, either up or down. CFDs allow you to take a long (buy) or short (sell) positions without actually owning or taking delivery of the underlying asset. This however is associated with a huge risk especially when you are in a short position.

If your speculation is wrong you will have to settle the price difference and pay it to the counterparty. Other risks associated to trading include low industry regulation, potential lack of liquidity and the need for adequate margin level.

In addition, contract for differences are not exchange-traded derivatives, therefore you will be exposed to counterparty risk. In most cases, the CFD provider is your counterparty.

CFDs are used widely by day traders because they get to close their positions before the day ends without accumulating fees and overnight interest. Traders register with day trading platforms that let you trade CFDs at a fees but when the market is volatile, spreads widen and finding a ready counterparty to exit or close their open position with can be challenging.

This leads most CFD day traders to keep their positions open overnight thus incurring overnight fees they tried to avoid in the first place. Many CFD traders also trade in illiquid assets and this also makes liquidity a problem.

CFDs are traded with leverage just like other derivatives, so every loss you make hits harder especially when you use excessive leverage like what brokers offer in unregulated jurisdictions in Africa and some parts of Asia.

Little to derive from derivatives trading

Without mincing words, derivatives are very risky and could lead to loss of principal capital and even further loss. Specifically, trading future can very dangerous. One tick move can lead to a huge loss of money. If you are wrong with your speculation, you are more likely to lose more than what you invested.

You could derive peace of mind if you stick to investing instead of risking it all. Derivatives are best for hedging risk, and should be handled by pros like hedge fund managers and automated high frequency trading firms.