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What Are the Pros and Cons of Derivative Securities?

Forms of derivative securities, futures and options, should only be handled by professional, experienced traders.
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  • Written By: Dana DeCecco
  • Edited By: A. Joseph
  • Last Modified Date: 12 July 2014
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Derivative securities are a useful and necessary investment tool, and the pros of derivative trading typically far outweigh the cons. Options and futures contracts are the most common form. The advantages of derivative trading include risk mitigation, contract flexibility, and leveraged speculation. The disadvantages are directly related to the misuse of these products, which can lead to large losses.

International commodities are bought and sold using derivatives. Futures contracts are derivative securities used for the exchange of commodities such as oil, gold and corn. Futures provide an efficient and effective means for the global trading of commodities. These standardized securities are traded on an organized futures exchange. The rules and regulations set by the exchange provide the advantage of organized commodity trading.

Futures markets offer highly leveraged trading. High leverage is normally considered an advantage to the professional trader or fund manager. The inexperienced trader might find that the use of high leverage can also be a disadvantage. Leverage magnifies losses as well as profits.

Trading in futures is a great advantage for the commodity trading participants. Future commodity prices can be locked in by buyers and sellers, and current asset values can be hedged against unfavorable price fluctuations. Speculators trade commodities using highly leveraged futures contracts. The exchange trading environment minimizes counterparty risk. Trades are backed and guaranteed by the exchange clearing house.

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Options are a form of derivative securities. The biggest advantage of options for the retail trader is the ability to trade in markets with a limited amount of investment capital. This advantage can quickly turn into a disadvantage for the under-funded or inexperienced trader, however, since a few bad trades could deplete a small account because of the high leverage provided.

The time decay of an options contract is a disadvantage for a buyer and an advantage to the seller. Unique strategies can be developed with options providing an advantage to both buyers and sellers. Options trading can limit risk while providing unlimited upside potential. The risk/reward ratio can be very good with these derivatives.

Derivative securities are complex financial instruments. Most beginners lack the knowledge and understanding required to successfully trade futures and options, and even professional traders can get into trouble through the misuse of derivative contracts. Individual traders as well as the financial markets in general benefit from the availability and flexibility of these securities, but education and experience are required to trade these complex products.

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Discuss this Article

andee
Post 6

There are several programs available that will teach you how to use derivatives to your advantage. Whenever you invest in the market, you are taking on some risk.

What I learned was how to manage the risk and how I could increase my profits if I learned how to use derivatives correctly.

This doesn't mean that I am profitable on every trade, but I keep my losses small and let my profits run. One of the best pieces of advice I can give if someone is interested in derivatives is to trade with paper money for several months before you invest with real money.

This will really give you a feel for what you are doing and by the time you are ready to invest your hard earned money, you will already have learned a lot of valuable information about how the derivatives work.

SarahSon
Post 5

I have never traded the futures, but got burned trying to make money trading options. What really hurt me was the time decay factor.

I would buy an option on a stock that I thought was going up. The frustrating thing is even if the stock did go up, I might still lose money on the option because I ran out of time.

I never could seem to get it right and decided enough was enough. There are several stocks I feel comfortable investing in and don't feel like I am putting nearly at much at risk investing in certain equity securities.

Mykol
Post 4

I have been active in the securities market for quite some time and recently attended a workshop on options. I found this to be very interesting, and think I can use options to enhance my trading.

One thing I really like about the idea of using derivatives is the leverage that is available. I don't have enough cash to buy a high priced stock like Apple. The only way I could afford to make money in a stock like this is to use options.

myharley
Post 3

@geekish-- You are correct about the higher cost of the option if the volatility is high. There is more than one way you can look at this. If you are selling options, you like a higher volatility because you will get more premium.

In markets where the volatility is low, that is a good time to buy options because you wouldn't be paying as much for them.

Options are very complex and take a lot of time to understand, but the reward is that there are some great ways to make money with them no matter which way the market is going.

geekish
Post 2

Another interesting fact about options trading is option volatility pricing. Options prices are related to the volatility of the underlying stock. Typically, the higher the volatility is, the higher the cost of the option.

snickerish
Post 1

You can see the derivative pricing of options on trade websites too -- I know my sister uses these a lot and she seems to do pretty well with it. The whole thing is just too confusing for me, you can keep your options and futures, I'll just stick with my compound interest savings account.

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