Stock Market Derivatives

What are Futures & Options? Is it safe to invest in Stock Market Derivatives?
Derivatives are specific investments that have no intrinsic value but derive their value over time from the performance of assets such as commodities, shares or bonds, interest rates, exchange rates, or indices such as a stock market index, consumer price index. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds. The two main types of stock market derivatives are: futures and options. 

Since derivatives offer the possibility of large rewards, it is very tempting for investors. Most financial planners caution against this because an investor in derivatives often assumes a great deal of risk. There is the danger that someone would lose so much money that they would be unable to pay for their losses. This might cause chain reactions which could create an economic crisis.

An option is a contract in which the buyer has the right but not the obligation to exercise the option within a specified time span. The seller has the obligation to honor the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium.

Futures are traded on a futures exchange and are a contract to buy or sell a certain underlying instrument at a certain date in the future for a pre-set price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price on the delivery date is called the settlement price.

A futures contract differs from an options contract in the following way: in futures contracts the holder or buyer has an obligation to buy while in an options contract, the holder only has the right to do so and need exercise that option. The risk to both the holder and the seller is unlimited. Both parties of a "futures contract" must exercise the contract to buy or sell on the settlement date.

A Futures contract can be of two types – going long and going short. The contract is called going long when the investor expects the price of the underlying security to rise. The holder will profit if the price goes up or suffer losses if the prices go down. The opposite of going long is going short. In this case, the holder acquires the obligation to sell the underlying commodity at the current price. He will profit if the price declines before the future date.

Futures are an incredibly risky investment vehicle and are sometimes used as a hedge by investors with the resources to devote a small percentage of their assets to this venture. It is too risky for individual investors.