Question

What are the three ways in which derivatives can be misused?

Answer 1

Lifespan - Derivatives are "time-wasting" assets. As each day passes and the expiration date approaches, you lose more and more "time" premium and the option's value decreases.

Direction and Market Timing - In order to make money with many derivatives, investors must accurately predict the direction in which the market or index will move (up or down) and the minimum magnitude of the move during a set period of time. A mistake here almost guarantees a substantial investment loss.

Costs - The bid/ask spreads of more common derivatives such as options can be daunting. An option with a bid of 5.25 and an ask of 5.875 means an investor could buy a round lot (100 units) for $587.50 but could only sell them for $525, resulting in an immediate loss of $61.50 before factoring in commissions.