“Derivatives aren’t for beginner or casual investors. Because they are essentially bets, Wall Street does a very good job of making sure they are accurately priced,” notes Rogovy.
“Derivatives aren’t for beginner or casual investors. Because they are essentially “bets”, Wall Street does a very good job of making sure they are accurately priced. Because derivatives tend to expire, there’s less margin for error — with securities, some bad trades may be salvaged by holding for the long-term. Inexperienced traders are notorious for losing significant amounts of capital on risky stock option bets. Many option trades risk losing the entire amount traded (or even more in some cases), whereas securities tend to have a “soft floor” where shrewd investors find value.
Advanced traders, on the other hand, stand to make more profit using derivatives than they could with the underlying spot positions. When pricing derivatives, Wall Street market makers tend to assume that the underlying asset price moves randomly. Traders with insight about the direction or timing of price movements can “bet” using derivatives at a fair price. It isn’t uncommon for derivative trade profits to exceed 100%, which is rare indeed for underlying securities.
Derivatives typically require a margin account, and new traders might not understand how it works or appreciate the risks. Regulators have recently fined a high-profile new stock brokerage $70 million for failing to adequately inform their clients about the risks of derivatives and margin.”