Do derivatives belong in a retail investor’s portfolio ? Russell Kwok, Remove Disclaimer: The author of this essay is not a qualified financial advisor and thus, all content is for informational purposes only and not to be treated as investment advice. Any loss is in no manner the responsibility of the author. It is very important to do your own analysis before making an investment. Derivatives are leveraged and complex securities and may incur substantial losses. To invest in such instruments, please follow all regulations and follow professional advice.
The recent volatility the financial markets, with fastest bear market on record in 19 days (LPL Research, 2020), have brought to mind the 2008 recession, which had led to financial catastrophe for millions of people around the world, in addition to the collapse of many renowned institutions such as Lehman Brothers. The current consensus of economists is that it was catalysed by investors gaining subprime credit exposure through derivatives. (Coghlan, et al., 2018) Thus, they are often derided as risky and complex. That view, however, is overgeneralising and may potentially exclude many opportunities that permit an intelligent investor to increase their returns, while derisking. (Asness, 2010) Truly, what harms investors is a lack of understanding. (Marolia, 2015) In view of these misconceptions, this essay will explore the types and structures of derivatives, the risk-reward ratio compared to other asset classes and examples where such securities are not only profitable, but beneficial for individual investors. Derivatives are defined as “financial securities with a value that is reliant upon or derived from, an underlying asset or group of assets”. (Chen, 2020) This is done through a contract in which a writer promises to deliver some value, or the underlying goods to the purchaser of this agreement. The earliest example of derivatives in use comes from Aristotle’s Politics. He recounts the activities of a fellow philosopher, Thales of Miletus: “he raised a small sum of money and paid round deposits for the whole of the olive-presses… and when the season arrived, there was a sudden demand for a number of presses at the same time… by letting them out on what terms he liked, he realized a large sum of money” (Aristotle, 1981) Thus, many who claim they are recent exploitative inventions of Wall Street are mistaken. In the latter example, derivatives were utilised for speculation, which is often mistakenly portrayed as their primary use in the financial markets. This belief is fallacious because there are actually multiple uses for such instruments; in fact, their invention was due to a need to facilitate hedging, which is still the most common use. (CFTC, n.d.) It means trying protects oneself against volatile asset prices by using derivatives to offset losses and gains on other securities they own; this is known academically as reducing variance. (Gilson & Black, 1993) Such ‘insurance’ is crucial for farmers and all sorts of businesses around the world who need to lock in prices to ensure costs stability and guaranteed payments. Another use is to adjust your asset allocation without transacting any underlying assets, so as to minimise frictional costs. For intelligent investors, in addition to hedging, one can write (i.e. sell) contracts to generate cash, often without buying or selling equities, and decrease cost basis
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