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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 to sell.

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.