Many people define themselves as e-mini merchants. However, the truth is that when you trade e-mini contracts, you are actually a derivatives trader. The massive market failure that occurred from late 2007 to 2009 is widely attributed to poorly structured derivatives. Futures markets were not generally blamed for the market crash, but another derivative called a credit default swap and a series of poorly structured forward contracts exacerbated the market’s downward trajectory as investment banks were unable to finance the derivatives they had subscribed in this category. . Many of the largest investment banks instantly went bankrupt due to their inability to cover CMO’s massive losses when the housing market crashed and they had to honor mortgages that were covered by credit default losses. As you probably know, they failed miserably in their responsibility in this regard and required massive injections of government cash to stay viable.
What is a derivative?
A derivative is a financial instrument that derives its value from an underlying asset. That is quite easy to understand. For example, the value of an ES contract is valued based on the price of the S&P index on the spot market. There are a multitude of derivative contracts out there and understanding the universe of these contracts could easily require a lengthy book to explain it. We will stick with the basics.
Institutional traders are the largest consumer of these products and typically use them to protect against losses on a cash position they hold. This is called coverage. On the other hand, smaller intraday traders often fall into the category of speculative derivatives traders. Speculative traders generally attempt to buy or sell these contracts at a price where they believe the market will move up or down and make profit or loss through short-term trading to take advantage of the volatile nature of these instruments.
How do derivatives work?
These contracts are traded in a zero-sum environment. For every merchant who buys an e-mini contract, there is a party that is willing to sell at the same price. The main concept to understand here is that for every winner there is a corresponding losing trader. This is the basic trading model to understand when trading futures. There are no incomparable operations like buying and selling on the New York Stock Exchange. It is not unusual to see major market movement stagnant because the supply of buyers or sellers is exhausted and the futures market stops, at least temporarily, in its tracks. There are derivatives on just about every commodity you can think of, from corn to weather futures. (that particular future still puzzles me)
What is the risk in futures?
There are several risks involved in trading derivative contracts, which, as I said before, include futures contracts. Volatility is the main concern for small traders, as futures contracts are highly leveraged and without proper money management, you can spend a wad of cash before you can say “boo.” Furthermore, the problem of the financial collapse that began in 2007 was counterparty risk. If you buy a futures contract, you should have reasonable assurance that the seller can honor his end of the deal. This is called counterparty risk and it was at the heart of the problems in the last market crash; investment banks had insufficient reserves to cover the commitments they assumed through credit default swaps and forward contracts.
In short, derivatives are used to hedge and speculate. They provide the necessary liquidity in financial markets, but that must be offset by the higher average risk associated with them. They are a marvel to trade, but it takes careful preparation to successfully trade derivatives. As always, good luck with your operations.
