FUTURES & OPTIONS: JACKPOTS OR TICKING TIME BOMBS?

As Buffett said, 'Derivatives are like hell; it’s easy to enter and almost impossible to exit.” Retail investors must stay away unless they are armed with sufficient knowledge and can take huge risks

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In the 2002 annual chairman's letter 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, carrying dangers that, while now latent, are potentially lethal.”

Further, Mr. Buffet said he viewed the derivatives and the trading activities that go with them as “time bombs.” After six years in 2008, he said, “Derivatives are dangerous.”

In India, former SEBI Chairperson Madhabi Puri Buch said she was “confused and surprised” at investors' interest in F&Os [futures and options] despite 90% of the individuals who invested in them losing money. NSE chief Ashishkumar Chauhan, Finance Minister Nirmala Sitharaman and Chief Economic Advisor V. Anantha Nageswaran have all flagged the growing risk of F&Os and cautioned against trading 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 primary asset based on which a derivative's value is derived at. They can be stocks, stock indices or commodities such as crude oil, natural gas, gold, silver, copper etc.