Business Times

Derivatives demystified

By Upul Arunajith

Derivatives are broadly classified as, Forward based Derivatives “Futures”, “Option” based Derivatives and OTC or “Over The Counter” Derivatives. OTC Derivatives and Futures are for the institutional investors for risk management and yield management of assets / liabilities. Average retail investor will be more involved in the Options market.

Awareness on Derivatives
The writer is a Sri Lankan derivatives consultant based in Canada. He will be writing a series on derivatives which will soon be introduced in the Colombo Stock Market. The first part in the series on introducing this instrument appears today and will be followed by -- Basic Terms; “Futures” vs “Options”; -“Call” vs “Put”; “Equity” vs “Option”; Equity Portfolio Insurance; Basic Option Strategies; Hedging Equity portfolio with options; and Hedging continued

Therefore, this series of articles will focus on Options for the retail investor’s benefit. The first Derivatives trade dates back to the 17th century and the underlying commodity was Tulip bulbs and the market was unregulated which lead to unprecedented “Leverage and Speculation”. Interestingly, Tulip was more expensive than gold! Leap forward to the 20th century, the market is structured, and transparent.

Gold takes lead role in the commodity rush with energy moving in tandem. Tulip Futures are non-existent. New contracts have been developed. Derivatives range from “weather” to “container’.

Current Crisis

The recent crash in the global capital market reveals one common thread between the 17th century primitive Derivative market and the 21st century matured Derivatives market. “Leverage” and “Speculation”! They were the twin evils that lead to the crash of the tulip market of the 17th century and the same mechanisms saw the crash of capital market in the 21st century.

Before we trade
The word “Derivative” is misunderstood. It’s use is seen as a gamble. From the retail investors standpoint the key to win the Derivatives game is to know:

  • Individual risk threshold
  • Trading objectives (expected return, risk control, cost reduction or purely speculative)
  • Know the position (trader or investor): Trader has a short term horizon and investor long term horizon.
  • Measure the performance regularly as market conditions change from second to second.

Not all trades will go in your favour as would not all trades go against you either. Even the investment Guru Warren Buffet recently lost millions in Derivatives trading but they were learning opportunities for the Guru.

Speculating, Gambling and Betting

The gambler knows nothing of a reliable event on which his gambling outcome depends on. He is driven by excitement in the event of a favourable outcome from an unknown situation. Gambling is a form of entertainment that the stakeholders at times will be rewarded. Even if there is no reward, the process is seen as a form of entertainment. Betting, is an offshoot of gambling with a definite win or lose: Being “right” or “wrong”.

The speculator walks a fine line between the gambler and the betting individual taking a directional view and calculated risk with risk capital. Speculating is an intellectual review and systematic analysis of uncertain future events.

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Derivatives demystified


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