With the wide range of financial instruments to be traded on the open market. the question many people are asking is: are derivatives safe for retail investors? To get a decisive answer to this question, it is important for retail traders and investors to understand what derivatives are. A financial derivative is simply a contract whose value is based on an underlying asset. This can be stocks, commodities, interest rates, treasuries and even currency. Whenever the value of the underlying asset fluctuates, the financial derivative is also affected. As contracts, derivatives must have two willing parties. There must also be a delivery date as well as an asset and money to be exchanged. When the contract expires, each party must meet their obligations.

Popular Types of Financial Derivatives

While there may be more than a dozen financial derivatives, the most common ones include swaps, options and futures. Every trader needs to know the definitions and differences between these derivatives as well as what they entail.

So, are Derivatives Safe for Retail Investors?

The answer depends on the type of derivative being dealt with. For instance, a swap is completely safe for retail investors since cash flow from one financial instrument is simply swapped with the cash flow from another. When it comes to options trading, retail investors can trade safely without exposing themselves to unnecessary risks. The good thing about options is that they are legally binding financial contracts that do not really bind the seller to sell (in case of a put option) or a buyer to buy the quantity of a commodity or stocks specified in a call option. This means that options are completely safe for retail investors. Futures, on the other hand, are somewhat more complex. In a futures contract, the parties must honor their end of the bargain. For instance, the investor who agreed to buy a specific quantity of a commodity at a certain price on delivery date must honor his or her end of the deal. What would a retail investor with little experience in the commodities market do with such a huge quantity of a commodity?

When it comes to futures, the question of safety must be overlooked shortly for a more important question: can retail investors afford to invest in futures? In real life, the answer is simply no, but with advanced online trading using leverage, traders can use a small amount of money to buy a futures contract worth thousands. The downside of using leverage is that it compounds risk and traders who open poor trades often lose more money than they have in their accounts. Institutional investors usually have huge sums of money and highly trained staff, so they rarely make losses, and if they do, they can absorb it comfortably.

That said, any type of investment always carries a degree of risk, and there arent any rewards for those who cannot take risks. So, are derivatives safe for retail investors? Hopefully, you now know the answer.