Many people define themselves as e-mini merchants. However, in truth, 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 collapse, 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 to in this category. . Many of the largest investment banks went out of business instantly due to their inability to cover massive CMO losses when the housing market crashed and they had to pay off mortgages that were covered by credit default losses. As you probably know, they failed miserably in their accountability 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 Cash Market Index. There are a multitude of derivative contracts out there and understanding the universe of these contracts could easily take a lengthy book to explain. We’ll stick with the basics.
Institutional traders are the biggest consumers of these products and typically use them to hedge against loss on a cash position they hold. This is called coverage. On the other hand, smaller day traders generally fall under the category of speculative derivatives traders. Speculative traders generally attempt to buy or sell these contracts at a price they believe the market will move up or down and will make a profit or loss by 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 trader that 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 exchanges like buying and selling on the New York Stock Exchange. It is not unusual to see a major market move halt because the supply of buyers or sellers dries up and the futures market comes to a halt, at least temporarily. There are derivatives on just about every commodity you can think of, from corn futures to weather futures. (That particular future still baffles 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 waste a lot of cash before saying “boo”. Also, the problem of the financial collapse that started 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 the crux of the problems in the last market crash; investment banks had insufficient reserves to cover the commitments they made through credit default swaps and forward contracts.
In short, derivatives are used to hedge and speculate. They provide the necessary liquidity in the financial markets, but that must be balanced against the above-average risk associated with them. They are great to trade, but careful preparation is needed to trade derivatives successfully. As always, best of luck in your trading.
