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in value if the stock price falls. In this way the investor uses derivatives as an insurance policy against losses vis-à-vis the stock he is holding. However, many people have discovered derivatives as investment tools in their own right and trade them just like other types of instruments.

What makes derivatives an attractive choice for people is the power of leverage. Each unit of a derivative normally corresponds to a number of units of its underlying security. The derivative holder does not own the underlying product (for that he would have to purchase the product directly), but he is said to be controlling it. Therefore for a little money the investor can control (indirectly) a lot of the underlying product (leverage). Now if the price of the product moves favorably (depending on the derivative positioning) the investor stands a chance to make a lot more profit than if he owned the product itself. This sounds like too much of a good thing, and you may be asking, what’s the catch? And indeed there is a trade-off here, otherwise everyone would invest in the derivatives and the underlying products would remain untouched (which also would not be a good thing for derivatives since they are based on the prices of the underlying products).

The catch is that derivatives expire or mature at specific dates, and if one cannot realize a profit, or at least get out even, before that date, one would lose part or all of the initial investment. The time factor gives derivatives a very risky characteristic.Unlike other types of instruments you do not have the luxury to hold on to your investment indefinitely until you see fit to sell. Your investment in this case has a specific amount of time (relatively short), to show profit or else it could become a loss. Another characteristic of derivatives is that they can be created (written) by ordinary investors and sold to other investors. Confused yet? Don’t be discouraged. It takes many people a long time to understand and correctly apply some of these concepts. Hopefully the …