A security can be anything including but not limited to stocks, bonds, mortgages, and commodities. Better yet, an option is an insurance policy. It is an insurance policy that can bought or sold by anybody in the world on anything of value in the world. The role that derivatives play in world financial markets has never been more relevant. Derivatives are used by banks, hedge fund managers, and we
althy investors alike. These financial tools were originally created to hedge losses for commodity prices. Farmers used derivatives to lock in current prices for future prices of the crops they produced such as corn, coffee, orange juice, and sugar. These insurance products allowed a farmer to lock in a price up front for the next season’s crop. If there is abnormally cold winter and the crop does poorly, the farmer still gets paid. If the harvest is strong the farmer would simply pay insurance policy (this is called a futures contract) and has money left over from the bushels of corn he sold. It’s called hedging and it’s as old as interest rates. These ever popular and increasingly complicated financial products have ballooned in size over the last few decades. The size of the derivative market is mind-boggling. As of today, banks and other institutions hold derivative securities valued at $1,600 trillion or $1.6 quadrillion. To give some perspective, 1 trillion seconds is 32,000 years. If the world’s derivatives were a debt, it would take 32 years to pay off if 100% of all world income was contributed each year. Why do I care? Well, a couple of reasons. Options can be bought by anyone with a brokerage account and by combining certain options spreads it is possible to profit from stock market volatility. I opened my first brokerage account with $5,000 and use income producing spreads to generate a small profit each month. Derivatives should not be played without doing some homework. A great way to learn is to open a free ‘play money’ account to test out strategies without loosing your life savings. With the plethora of tools offered by today’s trading platforms, anyone with basic understanding of chart reading and some common sense can potentially beat a Wall Street hedge fund manager. This is the good news. The bad news is derivatives have demonstrated tremendous affects on our financial markets. Warren Buffet calls them weapons of financial destruction. Derivatives were the pin that popped the massive housing bubble of 2007 and lead to the economic crisis of 2008 and the current debt crisis that many European countries are presently enduring. Any conversation about the economy needs to first address the 600-pound gorilla in the room that is the derivative market.
