In the annual letter of the 2002 president of Berkshire Hathaway, Warren E. Buffett, the Oracle of Omaha, wrote: “In our [along with Charlie Munger] View, derivatives are financial weapons of mass destruction, which have dangers that, although now latent, are potentially lethal. “
In addition, Mr. Buffet said he saw derivatives and commercial activities that go with the subject as “time bombs.” After six years in 2008, he said: “Derivatives are dangerous.”
In India, the former president of Sebi, Madhabi Puri Buch, said he was “confused and surprised by the interest of” investors “in F&O [futures and options] Despite 90% of the people who invested in them losing money. The Chief of the NSE, Ashishkumar Chauhan, the Minister of Finance, Nirmala Sitharaman, and the Chief Economic Advisor V. Anantha Negeswaran have marked the growing risk of F&S and warned against trade in derivatives. Why are there so many warnings against derivatives? Let’s see.
What is a derivative?
A derivative is a financial contract whose value depends on the price of an underlying asset. An underlying asset is the main asset based on which the value of a derivative is derived. They can be stocks, stock indices or products such as crude oil, natural gas, gold, silver, copper, etc.
For example, if the gold rate increases, then the rate of a gold futures contract in the exchange of multiple products (MCX) will also increase. Here, gold is the underlying asset for the golden futures contract.
Similarly, Nifty 50 is the underlying asset for the Nifty Futures Contract. In India, the two popular forms of derivatives are future and options (F&S).
What are futures?
Futures are contracts derived in which both buyers and sellers have a grimace of buying or selling an underlying asset at a predetermined price on a future date, decided today.
If a merchant thinks that the price of natural gas will increase in the next three months, you can buy a natural gas futures contract today. If your prediction is correct, you can obtain considerable profits. But if his prediction fails, he would incur an unlimited loss.
What are the options?
In an option contract, buyers have the right, but not an obligation, to buy an underlying asset through the purchase option, or have the right to sell an underlying asset through the sale option at a special price before a certain date. It is due to this flexibility, investors believe that the options are safer.
In fact, there is a popular saying: “If you want to exchange options, there are more options, but if you want to exchange futures, there is no future [for the trader]. “Although the options have more options, they are very risky, to the extent that their capital would be eroded to zero.
Option buyers suppose a maximum loss as only paid premium, as in theory. They are not aware that the premium loses value due to the passage of time (Greek option).
The premium amount is similar to ice cream that melts minute by minute due to decomposition in the time value. Are they active?
Retail investors trade in F&S under the case of diversification. But F&O are not long -term active; After the expiration of the contract, he cannot enjoy the possession of the underlying asset. Therefore, unlike the equipment, there is no matter of growth in the value of long -term referred.
Coverage tool
Derivatives are a useful tool for those informed merchants who use it as a coverage strategy (to mitigate losses), were the people that most retail investors enter the derivative market without adequate skills and knowledge and end up speculating in the market. If you play in the derivative market without conscience or knowledge, there is the risk of losing all its capital.
Risk of leverage
One of the main risks of derivatives is the leverage center, which allows merchants to take larger positions with relatively small capital, unlike spot markets.
Magnify losses
Merchants are attracted to the fact that leverage can magnify profits, but they are not aware that leverage can also magnify losses. Only a small negative movement in the price of the underlying asset can cause great unbearable/unrecoverable losses.
Then, maintained, greed brings a complaint. Derivatives are not certain awards to get excited and invest. They can also be marking time bombs. In more than 90% of cases, they are time bombs with potential to marry the savings of an entire life in the blink of an eye.
(The writer is a heritage manager certified by Nism & Crisil)
Posted on May 19, 2025
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