FAQ on derivatives

What is a derivative?

“A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes and stocks.”

Is derivative trading about trading in stocks?

No. Stocks are real assets that can be sold on an open stock market. You can’t sell a derivative on an open market like a stock. Why? Because it is a specific agreement between parties on the value of an underlying asset i.e. this is not ‘on the open market’. Making it very simple – perhaps too simple – a derivative is the ‘shadow’ of a real asset. In as much as you can’t hold a shadow in your hands, and do something with it in the ‘real world’, the same applies to derivatives. The real asset is for example a stock, currency or commodity. The derivative is the shadow of the real stock, currency or commodity. Nothing prevents contracting parties from trading the shadow value of the latter – as if it were a real asset. All they need is a contract on the notional (shadow) value.

Why the devil would anyone wish to trade shadows?

For the same reasons that people wanna trade real stocks, or currencies, or whatever i.e. to make some money.

But isn’t derivative trading dangerous – some guy a few years ago ended up in the slammer for doing dodgy stuff.

It is practically no more ‘dangerous’ than trading on ‘the stock market’, in legal terms. The guy is Nick Leeson, who was involved in illegal activity. Stock traders who do illegal stuff on the stock markets also end up in the slammer.

All financial trading is gambling, isn’t it?

Gambling is strictly about games of chance. There are people who throw their money into the stock markets as if they were rolling dice. They are certainly gambling. There are some people who go to casinos who are often called ‘card counters’. These folk have very sharp minds and a method that works against the ‘house’. They are usually banned from casinos if discovered. The equivalent of card counters in financial trading are not banned from markets.

I ain’t got money to trade derivatives – full stop! What’s the point?

That’s true also of purchasing a home. If you ain’t got the money and can’t access it, to purchase a home – you’re out. Nobody says you have to buy a house or deal in derivatives – or put your money at risk.

How risky is derivative trading?

At least as risky as dealing in the stock markets. At worst 10 to 100 times more risky, if derivative products are leveraged.

What does leveraged mean?

Leveraging is just like using a lever – in reverse i.e. a small movement at one end of the lever causes a large movement at the other end. So a leveraged derivative may cost £1 but it may represent 100 or 1000 (or more) units of the underlying asset. Instead of purchasing 100 shares at £100 each (for £10,000), your £1 may represent a lot of 100 shares. It would seem much easier to part with £1 but the risk of losses remains the same. A novice would probably think, let me buy £10 as I can afford that. But really that represents, £10 ‘derivatives’ x 100 shares. Each share would be normally be worth £100. So the actual money put at risk is 10x100x100 = £100,000. If the price of the share (the real asset) rises to £110 in say 8 weeks. The profit on selling the derivative (the shadow) is 10x100x10=£10,000, which is nice. But if price fell by £10 per share, then the loss is £10,000 – which is not so nice. A seeming £10 position has now caused a loss of £10,000!! This is a very simplified example – so it is not entirely representative.

All this derivative stuff is illegal – isn’t it?

No! Google is your friend.

How much money do I need to become a derivative trader?

Which is similar to asking ‘How much money do you need to become a doctor?‘ Anyone with access to the internet can open a derivative trading account with as little as £200 – that however does not make one a derivative trader. Similarly anyone can buy a few textbooks on medicine, read up some stuff and start practising ‘medicine’. That however, don’t make them a doctor.

Can anybody become a derivative trader?

Similar again to asking ‘Can anyone become a doctor?’ The answer is simply ‘no’. One can trade in derivatives or dabble in hocus pocus medicine and get into serious trouble.

How much does it cost to learn to become a derivative trader?

Two things are important: 1. Time 2. Dedication. You can learn most of the skills for free. Yes – you read that right and just to be clear, there are no strings, catches or gimmicks involved. Everything can be self-taught. No courses (or horses) required. There is no university course or fees involved.

How many people become successful derivative traders?

If you mean profitable traders, it’s only about only 0.000001% of people who sniff at it. But think – what percentage of people who say they wanna be the CEO of a blue chip company in their 20s achieve that, and by when?

Why so low?

Simply because 99% of those people would have tried their hand at it, got stung and decided incorrectly, “It’s gambling – not for me!”

Is there a risk free way to learn all about it?

Yes. In fact you can get free virtual money to learn and trade in a virtual market, so that you can acquire all the skills necessary. But unlike with a set course or university programme, your time, dedication, persistence and motivation are likely to be huge stumbling blocks. This also explains why so many who flirt with it drop out.

Is this about spreadbetting?

This post is about derivative trading. Spreadbetting is one type of derivative trading. Spreadbetting In the UK (but not in Australia), it is legally considered to be gambling by the HMRC. That’s fine because, all earnings that are not normalised by that route are tax free. However, spreadbetting is not gambling like at a casino. Contracts for Difference (CFDs) are another kind of derivatives. Earnings derived from trading in real assets such as the stock market are not considered gambling by the HMRC and are not tax free. The legal reason behind why trading ‘shadow assets’ based on true underlying assets, is treated as gambling by the HMRC is complicated and partly involves European law.

So are you making millions?

If I was, I wouldn’t be telling you! If I wasn’t I wouldn’t be telling you either.

So why the devil are you out here going on about all this?

It’s simply another way – to beat the usual financial system. I like showing people different kinds of opportunities. I do this for no financial gain whatsoever. I’m not a trainer in this field. There are thousands of so-called trainers out there on the net who provide courses for a fee, and provide tips etc. The reality is that they’re probably making more money from training than trading. And no – I have not set up this thread with a view to offering anything at anytime for sale or other advantage to me.