In a letter to Berkshire Hathaway, the 2002 annual chair, Warren E. Buffett, the oracle of Omaha, wrote: [along with Charlie Munger] Views, derivatives are financial weapons of mass destruction and now pose a risk that could potentially be fatal. ”
Additionally, Buffet said he viewed derivatives and the trading activities that come together with them as “time bombs.” Six years later in 2008, he said, “Derivatives are dangerous.”
In India, former SEBI Chairman Madhabi Puri Book said he was “confused and surprised” by investors’ interest in F&OS. [futures and options] Despite 90% of individuals who invested in losing money. NSE Chief Ashishkumar Chauhan, Finance Minister Nirmarashi Taraman and Chief Economic Advisor V. Ananthanagewaran all flagged the increased risk of F&OS and warned against derivative trading. Why are there so many warnings about derivatives? Let’s take a look.
What are derivatives?
Derivatives are financial contracts in which their value depends on the price of the underlying asset. The underlying asset is the main asset from which the derivative value is derived. They can be inventory, inventory indexes or commodities such as crude oil, natural gas, gold, silver, copper.
For example, as gold speeds increase, the proportion of gold futures contracts in Multicommodity Exchange (MCX) also increases. Here, gold is the underlying asset of a gold futures contract.
Similarly, the Nifty 50 is the underlying asset of the NIFTY futures contract. In India, two common forms of derivatives are futures and options (F&OS).
What are futures?
Futures are derivative contracts where both the buyer and the seller are obligated to buy and sell the underlying assets at a given price on a future date.
If a trader thinks that natural gas prices will rise in the next three months, he can buy natural gas futures contracts today. If his predictions are correct, he can make a significant profit. However, if his prediction fails, he will suffer unlimited losses.
What are the options?
Under the option agreement, the buyer reserves the right to purchase the underlying asset via the call option, but reserves the right to sell the underlying asset via the PUT option at a price specified prior to a specific date. This is because of this flexibility, and investors think the options are safer.
In fact, “If you want to trade options, there are more options, but if you want to trade futures, there is no future. [for the trader]. ” options have more options, but as long as your capital is eroded to zero, they are extremely dangerous.
Option buyers estimate the greatest loss as if only premiums are paid, as in theory. They do not realize that premiums lose value over time (optional Greek Theta).
Premium amounts are similar to ice cream that melts in minutes as time values decay. Are they assets?
Retail investors trade in F&OS under the diversification assumption. However, F&OS is not a long-term asset. After the contract expires, you will not be able to enjoy ownership of the underlying assets. Therefore, unlike stocks, there is no question about the growth in the value of derivative assets in the long term.
Tools for hedging
Derivatives are useful tools for informed traders to use as hedging strategies (to reduce losses) as hedging strategies, but most retail investors enter the derivatives market without the right skills and knowledge, and ultimately speculate in the market. If you gamble in the derivatives market without awareness or knowledge, you risk losing your entire capital.
Take advantage of risk
One of the main risks of derivatives is leveraged facilities. This allows traders to acquire larger positions with relatively small capital, unlike spot markets.
Increase losses
Traders are attracted to the fact that leverage can increase profits, but they do not realize that leverage can also increase losses. Even a small negative movement in the price of the underlying asset can cause major unbearable/irreparable losses.
So greed brings sadness. Derivatives are not specific jackpots to be excited about investing. You can also choke time bombs. In more than 90% of cases, they are time bombs that can ruin lifelong savings in the blink of an eye.
(The author is a NISM & CRISIL certified wealth manager)
Released on May 19, 2025
