Derivative securities are a useful and necessary investment tool, and the pros of derivative trading typically far outweigh the cons. Options and futures contracts are the most common form. The advantages of derivative trading include risk mitigation, contract flexibility, and leveraged speculation. The disadvantages are directly related to the misuse of these products, which can lead to large losses.
International commodities are bought and sold using derivatives. Futures contracts are derivative securities used for the exchange of commodities such as oil, gold and corn. Futures provide an efficient and effective means for the global trading of commodities. These standardized securities are traded on an organized futures exchange. The rules and regulations set by the exchange provide the advantage of organized commodity trading.
Futures markets offer highly leveraged trading. High leverage is normally considered an advantage to the professional trader or fund manager. The inexperienced trader might find that the use of high leverage can also be a disadvantage. Leverage magnifies losses as well as profits.
Trading in futures is a great advantage for the commodity trading participants. Future commodity prices can be locked in by buyers and sellers, and current asset values can be hedged against unfavorable price fluctuations. Speculators trade commodities using highly leveraged futures contracts. The exchange trading environment minimizes counterparty risk. Trades are backed and guaranteed by the exchange clearing house.
Options are a form of derivative securities. The biggest advantage of options for the retail trader is the ability to trade in markets with a limited amount of investment capital. This advantage can quickly turn into a disadvantage for the under-funded or inexperienced trader, however, since a few bad trades could deplete a small account because of the high leverage provided.
The time decay of an options contract is a disadvantage for a buyer and an advantage to the seller. Unique strategies can be developed with options providing an advantage to both buyers and sellers. Options trading can limit risk while providing unlimited upside potential. The risk/reward ratio can be very good with these derivatives.
Derivative securities are complex financial instruments. Most beginners lack the knowledge and understanding required to successfully trade futures and options, and even professional traders can get into trouble through the misuse of derivative contracts. Individual traders as well as the financial markets in general benefit from the availability and flexibility of these securities, but education and experience are required to trade these complex products.