Everything you need to know about derivatives risk.

Online Stock Trading Guide

What are the Risk Associated with Derivatives?

Most regular investors look at derivatives as the risky investment vehicle that wiped out California's Orange County government to the tune of $1.5 billion in investments and destroyed England's Barings Bank when an ill-informed trader bet against Japanese markets and lost.

To professional investors, derivatives are powerful tools for managing risk that, if handled correctly, can be quite lucrative. THe biggest risk in trading derivatives is the fact that you can lose a lot of money, and very quickly, when the event that you though was going to happen failed to occur. With advocates like US Money reserve available at your disposal, there are ways to save your money and your assets.

A derivative is an investment contract that depends upon prices or rates of other financial securities. For example, a computer manufacturer that buys component parts from Japan, would want to protect the component's prices against a rise in the value of the Japanese Yen against the U.S. dollar. That manufacturer would likely purchase a currency option.

In order to manage risk, investors must keep a careful watch on their positions. Another factor affecting the risk exposure in derivatives is a trend toward participants signing net agreements that require only the net value of all parties' positions to be replaced if there is a default. As an example, A owes B $150 million in one derivative contract; B owes A $100 million in a different contract. If A should go under and B is forced by contract to pay the $100 million it owes, B would still be exposed to the $150 million owed to it by A. This would create a gross credit exposure here of $150 million. On the other hand, suppose B and A have agreed that if either defaults, only the net of all contracts will be owed, not the gross. In this case the net exposure of B is only $50 million.

Many business schools are preparing students to deal with derivatives by offering MBA students one core course and five electives that include the topic. In addition, ongoing work by faculty members and doctoral students add to the understanding of the field. Today, the concepts of value at risk and volatility of options are becoming standard industry practice.

One of the most interesting things about derivatives is that they are a very risky tool that is, itself, used to manage risk. Of all the derivatives, futures contracts are probably the riskiest. When you buy a futures contract, you are obligated to purchase or sell a specific commodity by a set time and for a set price. The commodities involved usually include agricultural products (crops and animals), precious metals (gold and silver), oil and other energy products, and financial products (financial instruments and foreign currency). You can purchase futures contracts from the same brokerage firms you purchase stocks from, and you should expect to pay substantial commission fees.

Futures contracts are similar to stock option contracts, but they are much riskier because you have an obligation rather than an option to purchase or sell something. Therefore, you run the risk of losing a lot more than what you paid for your contract if you predict incorrectly on the way prices are going! And as difficult as it may be to predict the rise and fall of a stock, it's child's play compared to predicting commodity prices.

The bottom line is, unless you have great knowledge about a certain item and the market it moves in, or you have absolute, total faith that your broker knows what he's doing, this is not, we repeat, not, the place to put your investment dollars, no matter what age or stage of life you are in. While the profits are huge based on a small investment if the market moves your way, if it doesn't, your loss can easily be astronomical!

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