The mere mention of derivatives has the tendency to conjure up memories of Enron and of how the misuse of derivatives trading triggered one of the biggest bankruptcies in corporate America. Derivatives includes options, futures, and contract for differences CFDs. Derivatives have also suffered a lot of bad press focusing on the abuse and foolish use of derivatives without much coverage of how top hedge funds and Fortune 500 companies use derivatives as risk management tools.
The lack of adequate education on the proper use of derivatives has also caused many retail traders and investors to experience avoidable losses, which in turn precipitates a culture of aversion towards derivatives. Of course, you need understand the workings of the stock market, be able to manage your emotions, and stomach a higher than average risk. Below are four reasons you should consider derivatives as part of your trading and investment strategy.
It gives you unlimited access to the market
Traditional stock market trading and investing activities are restricted to happen between 9:30 Am and 4:00PM (EST). Hence, traders and investors are practically locked out of the markets for almost 18 hours in each 24-hour weekday. Interestingly, Ethel Marshall, an analyst at Olsson Capital notes that “the increase in internet penetration and shift towards conducting trading and investing activities on mobile devices means there’s practically no reason for the markets to be closed.”
If you are tech savvy and are already trading or investing through a mobile platform, derivatives might be a way to ensure that you don’t limit your exposure to traditional market times alone. Review of trading platforms shows that they offer you 24/7 access to the market, trading support in the form of artificial intelligence, and alert windows that stream and display market events as they happen.
It helps to limit capital exposure and generate additional income on current portfolio
Derivatives’ trading helps you to reduce your capital exposure to the market and it helps you limit your downside to the premium paid on the contract. When you buy derivatives, you are not buying the underlying assets outright, you are only buying a contract that gives you the right or option to buy/sell or execute a move on the asset sometime in the future.
Hence, you only pay a fraction of the face value of the asset to secure the contract. If the trade moves in your favor, the value of the contract increases and you can make money on the contract without actually “owning” the asset. If the trade goes against you, your loss will be limited to the money you’ve paid on the contract unless you’ve overstretched yourself with margin trades.
They provide an opportunity for short-term exposure to the market
Unless you are a day trader, investing in the stock market tends to be a long-term game. Jumping in and out of the stock market too often is akin to chasing shadows, and fees and commissions will wipe out whatever little gains you make. Derivatives are fundamentally investment opportunities with a shorter time-frame than traditional assets. Derivatives makes provides a faster route to market exposure because you don’t have to worry about liquidity or enduring an agonizing wait until the term of a traditional investment.
An unconventional tool for hedging and diversification
A traditionally accepted way to limit your downside to risk is to diversify your portfolio and edge your positions in the market. Most investors diversify their portfolio by buying up assets in different sectors, markets, and industries. Derivatives however expands the realms of possibilities available to your for diversifying your portfolio. You can buy derivative assets of just about any security, in any sector, and from practically any market.
In addition, you can also use derivative assets to hedge portfolio risks buying or selling derivatives contracts that have an inverse relationship with the undesirable events that could trigger losses in your original assets.