Financial Derivatives

Over the last few years no investment instrument has grown faster in popularity than financial derivatives. Thirty years ago there were very few derivatives being traded; now derivatives far exceed the stocks in terms of money invested. Because of the huge amount of money that is being traded on financial derivatives it is important that you know what they are and how to trade them.

Financial derivatives are futures and options which are traded on stocks, bonds and currency. Basically they allow you to bet on the future price of the underlying asset without owning it. This allows you to greatly increase your leverage which potentially can increase your returns, it also increases the risks. Over the last few years the derivatives market has become somewhat controversial, mainly because they are so widely used. There is now far more money traded on derivatives than there is on the underlying assets. This is a problem for a few reasons; the biggest is that it removes productive capital from the financial system. That being said used properly financial derivatives can be an excellent investment tool.

If you are going to invest in derivatives you need to make sure that you understand the difference between options and futures. A future is a contract that obligates you to buy or sell, depending on the position that you have taken the underlying asset for a set price on a set date. You are betting that the price of the underlying asset will be different than the price that you are committed to buying or selling at. Options give you the option to buy or sell the underlying security at a set price by a set date. Although the two instruments are similar the strategies for using them are very different.

Most people have the belief that financial derivatives are a high risk investment but that is just not true. The reason that this belief exists is that many of the large financial institutions trade derivatives in a highly risky way because the banking laws give them no incentive to remain cautious. However derivatives were designed as a risk management tool and they can be used to reduce your risk or to increase it depending on how you use them.

Financial derivatives really should be part of everybody's investment portfolio because they are a great risk management tool. Of course if you are going to trade derivatives you need to make sure that you learn how to use them properly. A lot of people are intimidated by the derivatives market because it seems so confusing. Admittedly it will take some time to figure it out but once you do it is fairly simple. If you really are uncomfortable with the idea of trading derivatives it may be best to have a money manager trade them for you. This will give you all of the benefits without your having to figure how the market works.