Binary Options: When investment becomes gambling

Binary Options: When investment becomes gambling

Introduction to derivatives

A derivative is a financial instrument whose value 
is derived from an underlying asset or group 
of assets. They are a contract between two or 
more parties. The value of this contract depends 
on changes in the value of the asset that the 
derivative’s value is derived from. Derivatives can 
also be thought of as bets on a change in price, 
or as insurance. Examples of underlying assets 
are stocks, bonds, and commodities. These 
derivatives are linked to a specific financial 
instrument or indicator or commodity, and 
through which specific financial risks can be 
traded in financial markets in their own right. 
Transactions in derivatives should be treated 
as separate transactions rather than as integral 
parts of the value of underlying transactions 
to which they may be linked. Unlike debt 
instruments, no principal amount is advanced 
to be repaid and no investment income accrues. 
Derivatives are used for a number of purposes 
such as risk management, hedging, arbitrage 
between markets, and speculation.
Derivatives enable parties to trade specific 
financial risks - such as interest rate risk, 
currency, equity, commodity price risk, and 
credit risk - to other entities who are more 
willing, or better suited, to take or manage these 
risks, typically, but not always, without trading 
in a primary asset or commodity. The risk 
embodied in a derivative contract can be traded 
either by trading the contract itself, such as with 
options, or by creating a new contract which 
embodies risk characteristics that match, in a 
countervailing manner, those of the 
existing contract owned. 
Derivatives contracts are usually settled by 
net payments of cash, often before maturity 
for exchange traded contracts such as 
commodity futures. Cash settlement is a logical 
consequence of the use of derivatives to trade 
risk independently of ownership of an underlying 
item. However, some derivative contracts, 
particularly involving foreign currency, are 
associated with transactions in the 
underlying item.

The value of the derivative derives from the 
price of the underlying item: the reference 
price. Because the future reference price is not 
known with certainty, the value of the financial 
derivative at maturity can only be anticipated 
or estimated. The reference price may relate to a 
commodity, a financial instrument, an interest 
rate, an exchange rate, another derivative, a 
spread between two prices, an index or basket of 
prices. An observable market price or index for 
the underlying item is essential for calculating 
the value of any financial derivative. If there 
is no observable prevailing market price for 
the underlying item, it cannot be regarded as a 
financial asset
.
Derivative products initially emerged as hedging 
devices against fluctuations in commodity prices, 
and commodity-linked derivatives remained 
the sole form of such products for almost three 
hundred years. Derivatives came into spotlight 
in the post-1970 period due to growing instability 
in the financial markets. However, since their 
emergence, these products have become very 
popular and by 1990s, they accounted for about 
two-thirds of total transactions in derivative 
products. In recent years, the market for financial 
derivatives has grown tremendously in terms 
of their variety, complexity and turnover. In the 
class of equity derivatives, futures and options 
on stock indices have gained more popularity 
than on individual stocks, especially among 
institutional investors, who are major users of 
index-linked derivatives. Even small investors 
find these useful due to high correlation of the 
popular indexes with various portfolios and ease 
of use. The lower costs associated with index 
derivatives vis–a–vis derivative products based 
on individual securities is another reason for 
their growing use.

Recently, the dangers and risks embedded in 
derivatives have come to the forefront. A major 
reason for this is because of counter-party risk. 
Most derivatives are based on the person or 
institution on the other side of the trade being 
able to live up to the deal that was struck. If 
society allows people to use borrowed money 
to enter into all sorts of complex derivative 
arrangements, we could find ourselves in 
a scenario where everybody carries these 
derivative positions on their books at large 
values only to find that, when it’s all unravelled, 
there’s very little money to circulate because 
a single failure or two along the way wipes 
everybody out with it. The problem becomes 
exacerbated because many privately written 
derivative contracts have built-in collateral calls 
that require a counterparty to put up more cash 
or collateral at the very time they are likely to 
need all the money they can get, accelerating 
the risk of bankruptcy
.
The following three broad categories of 
participants - hedgers, speculators, and 
arbitrageurs trade in the derivatives market. 
Hedgers face risk associated with the price of 
an asset. They use futures or options markets to 
reduce or eliminate this risk. Speculators wish 
to bet on future movements in the price of an 
asset. Futures and options contracts can give 
them an extra leverage; that is, they can increase 
both the potential gains and potential losses in a 
speculative venture. Arbitrageurs are in business 
to take advantage of a discrepancy between 
prices in two different markets. If, for example, 
they see the futures price of an asset getting 
out of line with the cash price, they will take 
offsetting positions in the two markets to 
lock in a profit. 

Binary Options: When investment becomes gambling