There are many investors who have lost a huge amount of money in derivatives trading.
In particular, the case of Orange County, California - which declared bankruptcy
in 1994 after losing $1.7 billion on derivatives trading, including unauthorized
deals has generated more than a dozen lawsuits in search of financial compensation.
Futures trader Nick Leeson caught the global financial headlines when he single-handedly
brought down one of the oldest banks in the world.
When Iraqi President Saddam Hussein invaded the tiny oil-rich Kuwait in the early
1990s, there was an immediate panic in the global oil markets. Speculators bet actively
in the futures market based on their various predictions - oil prices were either
going to tumble or skyrocket.
Commodity traders were betting using derivatives on the likely price of crude oil
causing it to change aggressively. According to some traders, what was actually happening
was not driving the market but indeed it was the speculation of what was going to
happen that affected the market. That explained why derivative products such as futures
are popular during periods of market turbulence. There were many traders who incurred
tremendous losses overnights but others managed to smile all the way to the banks.
The use of program trading supported by stock index futures and options was also
blamed by many for the famous crash on October, 19, 1987 (Black Monday) when the
Dow Jones Industrial Average dropped by a whopping 508 points.
In light of the magnitude of losses incurred in derivatives trading, it is no doubt
that many conservative Malaysians have been scared away from derivatives trading
without really knowing actually what they are - the usual problem.
The fact is that derivative products are getting increasingly popular among the global
players either for hedging or speculation purposes. It is important for the local
investors to know what are derivatives and to recognize the importance of these instruments.
What are derivatives? Derivative products such as options and futures are securities
that derive from other items. For example, stock index futures and options are considered
derivative products because they are derived from actual market indexes but have
no intrinsic characteristics of their own. In other words, the value of a derivative
security depends on the value of another asset such as the stock index in this case.
Over the past several years, derivative strategies left portfolio managers to invest
more effectively in the emerging markets. Derivatives trading such as options and
equity swaps are an exciting areas of investment for the emerging portfolio managers.
An option gives the trader the right to buy or sell at a fixed price over a specific
period of time. Specifically, a call is an option to buy while a put is an option
Options can be used to reduce risk. Options can be used to hedge various positions
against undesirable market uncertainty by gaining the right to buy or sell at set
prices, despite the market volatility. However, it can create substantial risks as
well depending on the market timing and direction factors.
Derivative securities such as the warrants or convertibles resemble options. A convertible
is like a regular bond or stock with an added feature that the investor has the option
to exchange for a fixed number of shares of the issuing company's stock. Meanwhile,
warrants are long-term call options issued by companies.
In the futures markets, futures contracts are traded actively by speculators or hedgers
daily. Simply, a futures contract is a contract between parties for any future delivery
of a security at a fixed price within a fixed time period.