In "The Divine Comedy," Dante, a thirteenth century Italian poet, describes a journey through hell. He must have been on the wrong side of a derivatives trade.

Mention derivatives to the average investor and visions arise of Long-Term Capital Management, a large hedge fund whose failed risk-arbitrage trading strategies nearly collapsed the global financial system in 1998, and Enron, where misuse of derivatives played a role in one of the largest bankruptcies in American history.

With this in mind, are derivatives even appropriate for the average retail investor? One aspect of derivatives is certain - they have an image problem. Read on to learn why derivatives have received such a bad reputation and whether this notoriety is deserved.

The Problem with Derivatives
There are four fundamental problems that contribute to the negative image of derivatives:

  • Bad press. If it isn't bad news, it isn't news. Stories in the press tend to focus on the illegitimate abuse of derivatives rather than how they are used legitimately.
  • Investors' misinformed perceptions and uninformed opinions.
  • Improper suitability given an investor's resources and temperament.
  • Lack of investor education.

The retail public reads these disaster stories and form opinions based on nothing else but what they read in the paper or see on television. The consequence of this is that the public tends to follow only the headline news and focus on the illegitimate abuse of derivatives, and they don't understand the historical advantages of using derivatives.

Who Uses Them?
Despite the well-publicized debacles, the growth in derivatives has been nothing short of remarkable. According to the Chicago Mercantile Exchange (CME), the S&P 500 mini futures contract (one-fifth the size of the normal contract) had its 10th anniversary in 2007. Furthermore, the average daily trading volume in that contract has reached more than 1 million contracts per day. In all equity products, that volume has reached 1.6 million contracts per day. Year-over-year growth from 2005 to 2006 has risen 30% in e-mini futures and a whopping 134% in the option contracts on those futures.

Data from Greenwich Associates' research of institutional investors and hedge funds indicates a clear preference: 80% of institutional investors use single-stock, listed and over-the-counter options, as do 96% of hedge funds. About 74% of institutional investors and 77% of hedge funds use index options. Index futures are used by two-thirds of institutional investors and half of hedge funds. Exchange-traded funds are used by 70% of institutional investors and 84% of hedge funds. All other strategies pale in comparison.

SEE: Futures Fundamentals: Introduction

Investor Perceptions
There are four fundamental perceptions or opinions the public has about derivatives.

It's an Institutional Market
Yes, it is. According to research conducted by the consulting firm Greenwich Associates, notional volume in interest rate derivatives for 2005 was nearly $1.5 trillion, 85% of which came from 260 institutions trading more than $1 billion each. Derivatives are a global marketplace - 27% originates in the United States and Canada, 63% in the United Kingdom and Europe and the rest in Asia and the Pacific Rim.

Derivatives Are too Complicated
Yes, some of them are. Think of the last time listed equity options were explained to you, even for something as simple as covered writing. Then you heard about puts and calls. Next comes bull spreads and bear spreads, then calendar spreads and butterfly spreads, then strips, straps, straddles and strangles. Have your eyes glazed over yet?

Derivatives are Expensive
Everyone deserves to get paid and this is not a public service. The products have become commoditized but the service and advice have not. How expensive would it be if you lost a large portion of market value because your portfolio was not hedged, or if you were over-exposed to a single issue? Potentially, the cost would be a great deal more expensive than the fee your firm charges on a derivatives transaction.

Derivatives Are Purely Speculative and Highly Leveraged
This objection relates directly to the use versus abuse problem. When hedging is used as a primary investment, they become extremely risky. The problem is that much of the investing public do not appreciate that when properly used, hedging can actually reduce risk, rather than exacerbate it.

Many retail investors equate risk in terms of leverage and market risk and hesitate to appreciate that leverage works both ways. It is commonplace for the public to not consider systemic risk, single stock ownership risk, event risk or credit risk. They also may not understand that some derivatives, such as futures and options, by definition, are contract markets. When used as an investment instead of a hedge vehicle, it's a zero-sum game.

The fact is, when used properly, derivatives tend to be no riskier than the underlying asset from which they are derived. When you use a hedge vehicle as an investment by itself, the risks grow exponentially. The major caveat is suitability for the investor; one size does not fit all.

Decreasing Vs. Increasing Risk
Does all this mean you can't or shouldn't get involved? No, of course it doesn't. The whole idea behind many derivative or alternative products is a non-correlated return. When used as a hedge vehicle, derivatives can enhance returns and reduce risk.

Years ago, there were futures contracts on agricultural commodities - this was the original derivative. These gave farmers the ability to lock in a price in a forward market and hedge their profits while speculators provided the liquidity to the market. That same principle hasn't changed. Given the number of derivative and alternative products available since that time, perhaps it's easy to understand why retail investors might find them confusing, if not intimidating.

However, considering the growth and use by institutional and hedge fund investors, something must be going right. Think about some of the investment strategies available in alternative investments. These would include such strategies as delta-neutral option trading, value-driven long versus short portfolios, volatility dispersion trading, capital-structured arbitrage and so forth. For a typical retail investor to even attempt to accomplish some of these strategies is unrealistic; they are so sophisticated, technology-driven and time-intensive that they require a full-time professional. Perhaps this is why managed money has seen the growth it has.

SEE: Are You Ready To Trade Futures?

Layman's Strategies
There are, however, some popular strategies for high net-worth investors that are worth considering.

For the high level executive with an overabundance of his or her own company's stock, there are strategies to pursue. The first would be access to exchange funds (not exchange-traded funds). These funds allow an executive to exchange restricted stock for a portfolio of other stocks. The second would be to employ certain options strategies within the context of governmental guidelines. The third options strategy would be to analyze strategic selling programs, again within governmental rules and guidelines.

Note: Before engaging in any strategy with restricted or controlled shares, it would be wise to seek the advice of legal and tax professionals first.

Another strategy for high net-worth investors is managed futures funds and/or hedge funds. Either of these asset categories also have a fund-of-funds approach. Remember, a non-correlated return is an important theme in many asset allocation models. Many major broker-dealer investment models call for a 4% allocation to managed futures and a 7 to 11% allocation for hedge funds, depending on the investor's education, financial resources and temperament.

One strategy for investors over the age of 50 is to use options strategies to produce income and protect principal, such as covered call writing with long puts. Another strategy is to replicate a stock portfolio with long-term equity options known as long-term equity anticipation securities (LEAPS). In this strategy, investors put 80 to 90% of a portfolio in fixed-income securities and the remaining balance in LEAPS for equity exposure. Please be mindful of any tax implications when using options.

Most broker-dealers have clear-cut suitability standards for retail investors, not only in terms of financial resources but in terms of education and temperament as well. There may also be suitability standards for the individual advisor in terms of tenure, background and experience. In addition, most firms will have progressively higher levels of supervision on client accounts involved in advanced strategies.

While the CME responds to clearing members' interests on the part of its clients, such as equity contracts, foreign exchange and, most recently, energy, it recognizes that other contracts such as eurodollars and interest rate swaps are clearly an institutional market and are not promoted to retail customers. The CME also considers options a step up from futures in the level of sophistication required for suitability. Its bottom line is that the level of sophistication is paramount to educational suitability.

There is certainly a need for advisory and broker-dealer firms to get involved in client education, much as the various exchanges have. The CME is an excellent example of how exchanges or firms can educate clients, as it offers seminars, webinars, CD-ROMs and printed materials for investor educational purposes.

The Bottom Line
Whether derivatives and alternative investments have a place in your portfolio is a question only you can answer. It all comes down to suitability. The guiding principle in the financial community is supposed to be "Know your customer." This principle isn't optional, so if you decide to jump into derivatives, be sure that you're the right kind of investor for this market.