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 word “trading” into a search engine and you'll be bombarded with a vast amount of offers by brokerage houses tempting you to open an account that'll help you obtain the financial independence you've been hoping for.
Yet one thing still evades the financial community; do novice traders truly understand how derivatives work?
Yet one thing still evades the financial community; do novice traders truly understand how derivatives work?
To find a suitable answer to the question I cast my mind back to when I first encountered the concept of derivatives during my time in varsity whilst studying finance and economics. I was in my final year so I had an elementary grounding in the basic knowledge of how financial markets operate and how their movements were induced. This is when I stumbled upon an exclusive investor’s newsletter advertising a very “lucrative secret” few people knew about in becoming instantly rich. I highlight the words "instantly rich" because you often learn too late in the process that instant isn't a frequent event in trading and the word rich is a fool's fallacy.
Being the curious creature I am, I decided to explore the topic further on the internet by researching various claims by brokers' in promising financial freedom. The results were staggering with claims ranging from “Make $2000 from $500 in just 3 weeks” to some sharing fictional stories of people who've had no prior knowledge to the workings of financial markets but were able to garner success with relative ease.
If it were easy why wasn't everyone else doing it then?
I opened a free 14 day trial account loaded with $100 000 demo capital to see if I could thrive as effortlessly as the people's stories shared on the broker's websites but to no avail. What I do remember from the experience which at that time involved very little analysis of any sorts and leaned more to "trade and hope it works out" without any real understanding of how traders timed their entry and exits from an instrument.
With a considerable amount of luck I was able to hit a winning streak by trading oil contracts back and forth on a minute to minute basis but this didn't last long as my guesstimation of where the price could be headed to was interrupted by a definite trend in the opposite direction of a contract I had just taken based on no analysis, effectively placing me in psychological warfare with my mind of what to do.
I opened a free 14 day trial account loaded with $100 000 demo capital to see if I could thrive as effortlessly as the people's stories shared on the broker's websites but to no avail. What I do remember from the experience which at that time involved very little analysis of any sorts and leaned more to "trade and hope it works out" without any real understanding of how traders timed their entry and exits from an instrument.
With a considerable amount of luck I was able to hit a winning streak by trading oil contracts back and forth on a minute to minute basis but this didn't last long as my guesstimation of where the price could be headed to was interrupted by a definite trend in the opposite direction of a contract I had just taken based on no analysis, effectively placing me in psychological warfare with my mind of what to do.
It's certain to say my interest in trading tapered down following this and the fact my trial period had ended meaning I would only be able to try out my skills as a trader if I used real money, something I wasn't prepared to do seeing I couldn't be decisive, a skill I flagged as being necessary in trading.
Refusing to give up I saw an opportunity in better understanding the process of trading by unpacking the concept around the instrument used in making it possible, that being derivatives. The course entailed learning how to calculate the price of different types of derivatives focusing on the more commonly known one's such as forward and futures contracts, options and swaps.
But that still didn't give me the solutions I was seeking to find which was if trading was a sustainable income generating activity that could amass wealth in a relatively short period of time.
What the course did highlight was the target market being advertised to wasn't fully aware of the complexities of managing such instruments and the proper use for them fell into the category of hedging away risk. The connection between those who understood the beneficial utility of using these tools and those chasing a financial pot of gold was so detached, the dangers of irresponsible use was accentuated to a frightening degree.
Refusing to give up I saw an opportunity in better understanding the process of trading by unpacking the concept around the instrument used in making it possible, that being derivatives. The course entailed learning how to calculate the price of different types of derivatives focusing on the more commonly known one's such as forward and futures contracts, options and swaps.
But that still didn't give me the solutions I was seeking to find which was if trading was a sustainable income generating activity that could amass wealth in a relatively short period of time.
What the course did highlight was the target market being advertised to wasn't fully aware of the complexities of managing such instruments and the proper use for them fell into the category of hedging away risk. The connection between those who understood the beneficial utility of using these tools and those chasing a financial pot of gold was so detached, the dangers of irresponsible use was accentuated to a frightening degree.
Going back to the question I posed earlier in asking if the stakeholders in the financial community were aware of the indiscriminate use of these instrument by the public in general in knowing they don't have the necessary understanding to operate with these tools, the answer is an emphatic YES.
In fact they falsely use the abilities of leverage to mesmerize the public on the wonders of gearing but fail to stress the extremities of risk when doing so.
They also possibly do so to keep the market liquid with easy prey to feed from with the more experienced trader looking to profit from insufficiency lurking around
But in saying this, derivatives have become part and parcel of the makeup of a trading business. Their use enhances a trader's ability to profit from minute incremental moves with efficiency where other means can't. They lower both transactional costs and barriers to entry with the theoretical aim of making the availability of all securities as freely as possible to allow for mass participation.
The importance of understanding every part of the trading process is nowhere stressed more so than in derivatives. From the amount of exposure you're willing to take on to where you place your stop loss, it all comes down to understanding and respecting the use of these instruments.
If you're goal is to be a long term profitable trader then you need to ensure that the products you choose, the securities you trade and the broker you deal through offer you a clear picture of what you'll be operating with. It's also important to remember that although your broker may offer you more gearing than you need, it's not a requirement or necessity to use all that's available.
Derivatives have tempting ways about them and somehow know just when to elicit the right responses from fear and greed respectively.
In fact they falsely use the abilities of leverage to mesmerize the public on the wonders of gearing but fail to stress the extremities of risk when doing so.
They also possibly do so to keep the market liquid with easy prey to feed from with the more experienced trader looking to profit from insufficiency lurking around
But in saying this, derivatives have become part and parcel of the makeup of a trading business. Their use enhances a trader's ability to profit from minute incremental moves with efficiency where other means can't. They lower both transactional costs and barriers to entry with the theoretical aim of making the availability of all securities as freely as possible to allow for mass participation.
The importance of understanding every part of the trading process is nowhere stressed more so than in derivatives. From the amount of exposure you're willing to take on to where you place your stop loss, it all comes down to understanding and respecting the use of these instruments.
If you're goal is to be a long term profitable trader then you need to ensure that the products you choose, the securities you trade and the broker you deal through offer you a clear picture of what you'll be operating with. It's also important to remember that although your broker may offer you more gearing than you need, it's not a requirement or necessity to use all that's available.
Derivatives have tempting ways about them and somehow know just when to elicit the right responses from fear and greed respectively.
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