When I was first introduced to the concept of derivatives a
few years ago the idea excited me. I got to work immediately on finding out
more about these financial creatures of wealth creation. It felt as if I was in
speculators heaven. I could take a position on the market both ways and not
have to tie up all my money doing it.
What could ever go wrong?
Type in the words
“derivative trading” and you'll be mesmerized at the amount of brokers offering
to open an account for you. But one thing still evades me; do novice traders
truly understand how derivatives work?
To answer that question I’m going to share with you my first
experience with derivatives. I was in my final year of varsity when I stumbled
upon an investor’s newsletter advertising a “secret” very few knew about. Still fresh in the game I was instantly
interested and read on further. All I had to do was subscribe to a monthly
service where a professional trader would send me a buy or a sell signal, what
could be more difficult? But wait…there’s more. Not only was I going to receive
monthly stock tips but I would receive a free guide, that’s right, a guide that
if I spent reading for a few hours was going to solve all my financial
problems.
Being the inquisitive person I am I had taken to search
engines to see how true these claims were and clearly they weren't far from the
truth. I had broker after broker telling
me how I could cash in on this new phenomenon. “Make $2000 from $500 in just 3
weeks” or “It’s so easy and painless, one click away from your financial
freedom” and my personal favourite “I had never been involved in financial
markets but today I’m earning a living from it”.
I thought I better try this out and see for myself and
signed up for a free 14 day trial. My demo trading began within a few minutes
of registration. Wow! Life was fast when it came to trading. Buying and selling
at galactic speeds with some winning and others dead losers. I had no idea what the contract
specifications represented, all I knew is that large sums of money were going
in and out at rapid pace. Something still puzzled me at the time, yes money was
coming in but could this be sustainable?
My interest tapered down after my trial period had ended. I
had seen a module in my varsity course which offered an introduction to
derivatives. I immediately thought it would be a great idea to unpack the
concepts and was almost certain that it would unlock the “secret” that had
escaped me thus far. This is when it hit
me in the face like a ton of bricks.
Going through the work wasn't easy at all; it involved
financial mathematics and complex equations.
It went into detail about the type of contracts you get, how they are
used, who uses them mostly, why they were created, on which securities you can
use them on and so on. It was recommended by the university to spend at least
120 notional hours on the module, I ended doing 200 hours. But I can confidently say that those 200
hours were the best amount of time I have ever spent on really understanding
how things work.
If I hadn't taken that module I would be none the wiser to
the complexities involved in derivatives. It heightened my awareness to the
possibilities derivatives held both positive and negative. It also made me sit up and think about the
people who don’t have any financial literacy or expertise; how lucky I was to
have been afforded the opportunity to learn about these mechanisms which so few
know about.
To answer the question I posed earlier on I would say no, I
don't believe all traders fully understand how derivatives works which is why I
have set out on raising awareness to as many traders as possible so that their
fate does not end up the same as the fate of traders gone bust. The reality of trading is that for a trader to
ensure his long term success they need to fully understand every aspect of
their trading process and that includes the tools and products they work with.
Derivatives are essential tools in trading. They effectively
lower the barrier to entry into trading by borrowing exposure at a fraction of
its full value which makes it a very attractive proposition to many. Although the capital required has been lowered,
we should not forget that the time and experience needed to succeed far
outstrips any amount of money contributed to the trading journey.
The real risk with derivatives comes from the trader who is
unaware of its potentially destructive ability to erode his account to zero in
a short span of time. The leverage which
is offered is most often misunderstood which leaves the trader in an
overexposed position and vulnerable to the turbulent market conditions often
experienced.
This is why it is imperative that when you wish to start
trading you equip your mind with enough knowledge and conceptual understanding
of the nature of derivatives, paying particular attention to the leverage. Accept that although your broker is able to
provide you gearing of up to 20 times in some instances, it does not
necessarily mean you need to fully subscribe your capital to it. It’s important
to remember that derivatives will always be around, they have been for many
years but your trading capital won’t if you don’t employ responsible risk
management principles.
Finally, no trade is
worth the money if it makes you lie awake at night. Trading can be a very
stressful task which is exacerbated when a trader tries to test his courage
with a higher than usual position. It doesn't make you a better trader
competing against the market, rather respect it and leave the bravado at the
front door.
If you would like to contact me you can through my email at cadetrader@gmail.com or if you wish to
follow me on twitter and get the latest updates of news, interesting commentary
and general trends in the market, my twitter handle is @CadeTradeR if you
follow this link it’ll take you directly to my twitter timeline: https://twitter.com/CadeTradeR
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