First-time traders need to do their homework before dabbling with derivatives

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October 11 2021
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New retail investors should be careful not to let the potential returns offered by derivatives overshadow the risks involved.

While many new investors find their start with standard stocks, more modern exchange-traded funds or even cryptocurrencies, it usually doesn’t take long for derivatives to cross their radar.

Speaking to nestegg, eToro market analyst Josh Gilbert explained derivatives are financial products that derive their value from a second underlying asset.

That asset can be a stock, commodity, index, currency or bond. It really depends on the nature of the derivative itself. In any of the above cases, a derivative essentially works like a contract.

“Put simply, an investor enters into an agreement to exchange the difference in the price of an asset from the time they open the trade to when it is closed,” Mr Gilbert explained.

If the price of an asset goes up, the returns on a derivative contract can be lucrative. However, in the opposite scenario, the losses can be substantial.

Since they allow investors to speculate on the rising or falling of another market or asset, Mr Gilbert said that derivatives have become popular as a tool for investors looking to minimise their losses through hedging.

“In most cases, new investors should do plenty of research before looking at derivatives, as they are a high-risk investment product,” Mr Gilbert said.

He noted that retail investors using eToro don’t have access to derivatives until they’ve demonstrated that they “appropriately understand” the products and risks involved.

Even then, eToro makes risk management tools like stop losses mandatory for retail investors, mitigating their risk when it comes to trading complex products like derivatives.

As with any form of financial asset, Mr Gilbert insisted that investors need to consider their risk appetite carefully when it comes to investing in derivatives.

“It’s also wise for investors to aim to diversify their portfolios with a range of assets, only invest in markets and assets they are familiar with, and invest capital they can afford to comfortably lose,” he concluded.

One recent report suggested that the explosive rise of retail trading during the pandemic has effectively spilled over into the derivatives market.

Earlier this year, Taiwan Futures Exchange chairman Tzu-hsin Wu told Funds Global Asia that it was “heartening” to see the increase in activity on futures exchanges.

“It is essential that appropriate derivatives products are not only available, but also accessible to market participants of all sizes,” he said.

About the author

Fergus is a journalist for Momentum Media's nestegg and Smart Property Investment. He likes to write about money, markets, how innovation is changing the financial landscape and how younger consumers can achieve their goals in unpredictable times.

About the author

Fergus is a journalist for Momentum Media's nestegg and Smart Property Investment. He likes to write about money, markets, how innovation is changing the financial landscape and how younger consumers can achieve their goals in unpredictable times.

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