Pros and cons of derivatives
Pros of derivatives
Trading derivatives can be used to hedge: a method of minimising losses to other positions. This is because derivative products offer a larger amount of flexibility when compared to trading the underlying asset directly.
With traditional investing, you open a long position – buying an asset in the hope that it rises in value. But with derivatives, you can also speculate on markets that are falling in price – this is done by opening a short position.
Some derivative products are traded on margin, which means that you only need to put down a fraction of the value of a position to receive full market exposure. Any profit to the position is calculated using the full value of the trade, which can mean that returns on successful trades are magnified. However, it can also amplify your losses. This makes it important to consider your trade in terms of its full value and downside potential.
Cons of derivatives
Derivatives are sometimes criticised for adding to market volatility. In the past, speculators have been accused of greed during times of increasing fuel and food prices, and for causing drastic swings in the markets. Price movements fuelled by speculation can lead to speculative bubbles, which push the intrinsic value of an asset above its normal market price.
When speculative bubbles burst, the effects are often devastating on the markets and even on the economies of countries around the world. This happened in 2008 when the American housing bubble burst.