Derivatives are securities linked to other securities, such as stocks or bonds. Their value is based on the primary security they are linked to and they are therefore not worth anything in and of themselves. Most investment and financial engineering strategies revolve around the following:

  • Options – contracts between two parties to buy or sell a security at a given price.
  • Futures work on the same premise as options, although the underlying security is different.
  • Swaps give investors the opportunity to exchange the benefits of their securities with each other.

The advantages of Derivatives are:

  •  They are a Non-Binding Contract so when investors purchase a derivative on the open market, they are purchasing the right to exercise it. However, they have no obligation to actually exercise their option. However, some derivative classes (such as certain types of swap agreements) are actually legally binding on investors, so it’s very important to know what you’re getting into.
  • Leverage Returns give investors the ability to make extreme returns that may not be possible with primary investment vehicles such as stocks and bonds. When you invest in stock, it could take seven years to double your money. With derivatives, it is possible to double your money in a week.
  • Advanced Investment Strategies – Financial engineering is an entire field based on derivatives. They make it possible to create complex investment strategies that investors can use to their advantage.

Derivatives are complicated financial instruments and unsuitable for retail investors because:

  •  Due to their volatility, it is possible for them to lose their entire value overnight.
  • Derivatives are very difficult to value because they are based on other securities. Since it’s already difficult to price the value of a stock, it becomes much more difficult to accurately price a derivative based on that stock.
  • The biggest reason derivatives are risky is they have a specified contract life. After they expire, they become worthless and you will face a 100% loss.
  • Many people don’t understand derivatives so they are often used to build complex scams. The Bernie Madoff Ponzi scheme is a good example of this.