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Derivatives - Criticisms of Derivatives

Options offer the potential for huge gains and huge losses. While the potential for gain is alluring, their complexity makes them appropriate for only sophisticated investors with a high tolerance for risk.

  1. When a derivative fails to help investors achieve their objectives, the derivative itself is blamed for the ensuing losses when, in fact, it's often the investor who did not fully understand how it should be used, its inherent risk, etc.
  2. Some view derivatives as a form of legalized gambling enabling users to make bets on the market. However, derivatives offer benefits that extend beyond those of gambling by making markets more efficient, helping to manage risk and helping investors to discover asset prices.

While professional traders and money managers can use derivatives effectively, the odds that a casual investor will be able to generate profits by trading in derivatives are mitigated by the fundamental characteristics of the instrument:

Lifespan - Derivatives are "time-wasting" assets. As each day passes and the expiration date approaches, you lose more and more "time" premium and the option's value decreases.

Direction and Market Timing - In order to make money with many derivatives, investors must accurately predict the direction in which the market or index will move (up or down) and the minimum magnitude of the move during a set period of time. A mistake here almost guarantees a substantial investment loss.

Costs - The bid/ask spreads of more common derivatives such as options can be daunting. An option with a bid of 5.25 and an ask of 5.875 means an investor could buy a round lot (100 units) for $587.50 but could only sell them for $525, resulting in an immediate loss of $61.50 before factoring in commissions.

Arbitrage
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