Could You Explain to Your Neighbor How Derivatives Function?

Many individuals define themselves as e-mini traders. In truth, though, when you trade e-mini contracts you are actually a derivative trader. The massive market failure that transpired from late 2007 through 2009 is widely blamed upon poorly structured derivatives. The futures markets were not usually blamed for the market collapse, but another derivative called a credit default swap and a number of poorly structured forward contracts exacerbated the downward trajectory of the market as Investment Banks were unable to fund the derivatives they had written in this category. Many of the largest Investment Banks were instantly bankrupted due to their inability to cover the massive losses on CMO’s as the housing market tanked and they had to make good on the mortgages that were covered by the credit default losses. As you are probably well aware, they failed miserably in their responsibility in this respect and required massive infusions of cash from the government to stay viable.

What is a derivative?

A derivative is a financial instrument that derives its value from an underlying asset. That is pretty easy to understand. For example, the value of an ES contract is valued based upon the price of the cash market S&P index. There is a multitude of derivative contracts out there and to understand the universe of these contracts could easily take a lengthy book to explain. We will stick with the basics.

Institutional traders are the largest consumer of these products and they generally utilize them to hedge against loss in a cash position they hold. This is called hedging. On the other hand, smaller day traders usually fall under the category of speculative derivative traders. Speculative traders generally try to buy or sell these contracts at a price where they believe the market will move up or down and realize a profit or loss by short-term trades to take advantage of the volatile nature of these instruments.

How do derivatives work?

These contracts are traded in a zero-sum setting. For every trader that purchases an e-mini contract, there is a party who is willing to sell at the same price. The primary concept to understand here is that for every winner there is a corresponding losing trader. This is the basic trading model to understand when trading futures. There are no unmatched trades like buying and selling on the NYSE. It is not unusual to see a major market move stall because the supply of either buyers or sellers dries up and the futures market comes, at least temporarily, to a screeching halt. There are derivatives on just about every commodity that you can imagine from corn to weather futures. (that particular future still baffles me)

What is the risk in futures?

There are several risks involved in trading derivative contracts, which as I said prior includes futures contracts. Volatility is the primary concern for small traders as futures contracts are highly leveraged and without proper money management you can blow a wad of cash before you can say “boo.” Further, the problem in the financial meltdown that started in 2007 was counter-party risk. If you buy a futures contract you have to have reasonable assurance that the seller can hold up his end of the bargain. This is called counterparty risk and was the crux of the problems in the last market crash; the investment banks had insufficient reserves to cover the commitments they made via credit default swaps and forward contracts.

In summary, derivatives are used to hedge and speculate. They provide needed liquidity in financial markets but that must be counterbalanced with the above average risk associated with them. They are a blast to trade, but careful preparation is needed to trade derivates successfully. As always, best of luck in your trading.