Are Derivatives Right for Individual Investors?

Are derivatives appropriate for the retail investor's portfolio?

Jan 13, 2009 Dean Lundell

Futures and options and are not for the amateur or uninitiated investor. Only the individual can make that decision but don't let false assuptions make up your mind.

An age old cliché joke on Wall Street is "how do you make a million dollars in futures?" Start with three. A fundamental problem with derivatives in general and futures in particular is that they suffer from an image problem. A sad fact is that too many people have entered this market without the proper education or mindset. Letting your ego make trading decisions is a very bad and often humbling experience.

It’s Not News if it isn’t Bad News

The press loves a scandal and the financial community has had more than its fair share. The public often equates derivatives with Long Term Capital Management, Enron and Orange County with executives being led away in handcuffs. Now there are $50 billion Ponzi schemes. How much all this bad publicity contributes to investor apathy is open to speculation of course. No pun intended.

There are several factors that contribute to this investor apathy: The old adage in the news business "if it isn’t bad news, it’s not news", the public at large having misguided perceptions and uninformed opinions regarding futures and options, improper suitability given an investor's financial resources and temperament and a lack of investor education.

The end result is the investing public forms opinions about derivatives based on nothing more than conjecture that focuses on the illegitimate abuse of derivatives rather than on the legitimate use of them.

Academic Arrogance vs. Reality Check

Not to disparage the value of an education but formal education is not a guarantee of success. That is why it’s called "academic." One of the first rules of trading is do not let your ego make decisions. There is no hoping, no wishing, no praying and no opinions. Economists can get away with having an opinion; traders cannot. Remember why "assume" is spelled the way it is.

Despite the bad publicity, growth in derivatives has been robust. It would be worthwhile to take a look at who does trade derivatives. Statistics from Greenwich Associates show that 80% of institutional investors use single stock futures and 96% of hedge funds do while index options are used by roughly three-quarters by both of those entities and 70% of institutional investors and 84% of hedge funds use Exchange Traded Funds (ETF).

Some Rules for Playing the Game

There are a few guidelines that the individual investor should be aware of before getting involved in futures and options.

First, be aware of the large proportion of institutional investors. You will be in the same arena, for better or worse, as professionals. Second, derivatives and the interrelationship to other asset classes can be complicated. That doesn’t mean you can’t learn them. Third, derivatives are purely speculative and highly leveraged. Highly leveraged to be sure but whether they are speculative depends on your use of them.

Last, learn how to play the game. The Marine Corps has sent commanders to the floor of the futures exchanges to observe how traders deal with the ebb and flow of the market and how they react and deal with adverse conditions. Remember, both the futures and options markets are contract markets; by definition they are a zero sum game.

All the exchanges have educational departments. Take advantage of them. Know yourself and learn the markets – that isn’t an option.

The copyright of the article Are Derivatives Right for Individual Investors? in Investment is owned by Dean Lundell. Permission to republish Are Derivatives Right for Individual Investors? in print or online must be granted by the author in writing.

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