Why using derivatives?
A derivative will pay a payout at a certain time in the future. This exposure can be acquired to match your economic interest.
If you acquire this exposure to eliminate an existing exposure, you are ‘hedging‘ a risk. Here are a few examples:
- A farmer sells some of his wheat in advance utilizing a wheat futures contract, to ensure enough income to pay his employees.
- Meanwhile, the bread-maker buys a wheat futures contract, so that he can guarantee the production price of his bread.
Both the farmer and the miller have eliminated the risk that wheat price goes against them.
- An airline company buys an oil futures contract as soon as it sells a plane ticket, so that it isn’t exposed anymore to the risk of a rising oil price.
- Meanwhile, an oil producer in Texas sells oil futures, to have price certainty, as he expects that OPEC will increase its production quota by the time he has pumped his barrel out of the ground, an increase of quota would cause prices to fall.
These trades are a zero-sum game in dollars, but they are not zero-sum games in risk; both parties have reduced their risks, as they had opposite interest.
Alternatively, you can use derivatives to acquire a risk exposure, based on your analysis and view of the future. You are speculating that the risk will go in your favor.
- For example, a portfolio manager, representing the retirees from the teachers of Middlestate America, who believes that equity markets will go down when the recession hits, sells an S&P 500 futures on CBOE.
The equity markets may go down, or they may not. He or she is speculating on the market’s direction.
Benefits of derivatives
The main benefit of derivatives is to trade risk: you can eliminate an exposure which threatens your economic activity, or you can add risk for speculation or investment purposes.
Adding or eliminating this risk is usually executed with a much smaller execution cost (brokerage, commissions).
Also, you may need only a fraction of the capital represented by the risk – the initial margin for the futures or the collateral for the OTC is usually much lower than buying the asset itself. This lower ‘margin’ requirement means that you can further leverage your capital.
A few other marginal benefits:
- There is no uptick rule for derivatives. When you sell a stock short (meaning that you sell the stock without owning it), you are not allowed to hit the bid. You have to remain on the offer and wait for someone to lift your offer. That selling restriction is called the ‘uptick rule’. There is no uptick rule for derivatives. If there is a bid, you can always sell at that price without having to wait.
- Listed derivatives are easy to short. A derivatives contract always has a buyer and a seller at the same time. By construction, every time a contract has an open position, there are always as many short sellers of this contract as there are buyers, and the exchange makes sure that selling a contract is as easy as buying one.
- There is no borrowing fees for contracts: there is no equivalent of the ‘stock loan‘ for selling a stock short.
Downsides of derivatives
The same arguments listed as benefits can turn adverse:
- You can take the wrong risk at the wrong time, very efficiently.
- Since you can trade on margin, you may over-leverage yourself and over-extend your financial capacity.
Other downsides of derivates include:
- do you follow On top of the market risk, derivatives often also bring counterparty risk.
- Trading by the book a derivative on an exchange does not necessarily make the trade legal, if your intent is wrong. Insider traders tend to buy call options to take advantage of their implicit leverage. Trading the option will not eliminate the legal risk. Not only the regulators know the trick, but the leverage actually increases the penalties!
- You may also have regulatory risk: do you have the right and the requirements to trade derivatives? What if the regulatory environment change?
- You may not properly understand all the risks you are taking. There are complex mathematical and technical issues associated with derivatives. They are far from obvious. Actually, the more complex the derivative, the more tricks and traps it contains. There are already many of these in listed options…