Derivatives allow savvy stockbrokers and traders to earn higher returns on financial equities. These financial instruments make it possible to profit from both rising and falling equity prices. Derivative trading is not appropriate for all traders since potential losses may exceed the amount of the initial investment. Nevertheless, equity derivatives are an effective means of diversifying a trading portfolio, transferring risk to another party and taking advantage of underlying price fluctuations.
There are many types of equity derivatives available to equity traders throughout the world. Stock option trading, for example, is a popular way for equity traders to speculate or create a hedge against potential risks. With stock options, the option holder has the right to buy or sell an equity at a specified price. The stock option contract must be exercised by a prescribed date of expiration. Other types of derivative instruments include single stock futures and index return swaps.
Are Derivatives Dangerous?
Derivative trading really took it on the chin during the 2007-08 financial crisis. The mortgage market suddenly collapsed largely because of derivative contracts. The derivative contracts were based on the notional value of the underlying mortgages. Unfortunately, the notional value of the underlying mortgages greatly exceeded the actual value of the securities. Put simply, the derivative market was riddled with phony accounting practices.
When a seemingly healthy company falls prey to the dangers of misleading accounting practices, innocent investors are at risk. Enron and Lehman Brothers will forever be remembered for succumbing to a derivative related fiasco. Perceived derivative values tend to deceive equity markets when multiple derivative contracts are based on the same underlying assets. This was certainly true of the mortgage crisis that occurred in 2007-08.
The uncertainty surrounding derivative notional values makes derivative trading complex. Derivative contracts are traded throughout the world, making it difficult for regulators and traders alike to obtain accurate data. Derivative contracts have a tendency to concentrate risk. Megabanks can use derivatives to avoid capital requirements by trading risk to other firms while keeping the notional value of the assets on their books. An unexpected downturn in the financial markets can suddenly create havoc for exposed traders.
The Ethics of Derivative Trading
All it takes is a good financial crisis to raise concerns about the ethical soundness of derivatives. The fact remains, however, that derivatives are an effective instrument for building financial wealth. Guarding against risk is an essential aspect of growing a portfolio. Moreover, qualified professional stockbrokers know how to evaluate the risks associated with the derivatives market.
Many financial professionals claim that the problem with derivatives has more to do with the users than the derivative instrument itself. Derivatives make it possible to alter the risk profile of an informed investor. There are derivative instruments that are genuinely in the best interest of a firm or individual investor. Banning derivatives, as many high profile politicians and pundits have suggested, would do more harm than good. Derivatives have become controversial because they are often misused by unethical traders.
The incentive to attract investors by bloating stock prices will always be alluring. Risk is an inherent aspect of investing and life in general. Ethical financial trading always requires professional standards and sufficient monitoring. When a financial market melts down, there’s every reason to believe that the ethical aspect of derivatives trading was once again ignored.