284 Chapter 6 Investmentspossibilities are nearly unlimited. These more exotic possibilities fall far outside the scope
of this chapter. We mention them here only to make sure the reader is aware of the immense
possibilities that exist in the derivatives markets.Uses and Dangers of Options and Futures
Options and futures can provide a valuable tool for both businesses and investors. They
allow businesses to hedge against unfavorable changes in prices, enabling them to control
and limit the risks that price fluctuations can pose. They can also help limit investment
risks; if an investor has a large investments in stocks and is concerned about the possibil-
ity that the market may decline, he can buy put options on the stocks he owns, or on some
market index. Instead of having to bail out of his investments altogether, he can use options
as a kind of insurance. A company doing business overseas can “insure” itself against the
risk of foreign currency fluctuations with foreign currency futures or options. In each of
these cases, and in many, many others, derivatives can help reduce risk.
Unfortunately, options and futures also present the potential to create immense financial
risk. Their leverage makes it possible for an investor to make huge bets with comparatively
little money, and the potential for astounding profits can lead to the temptation to overlook the
potential for astounding losses. While there are many legitimate uses of derivatives, they can
easily be misused, with financially disastrous consequences. These risks are magnified by the
incredible complexity that derivatives can entail. Even fairly basic derivatives can be confus-
ing, and some of the more exotic possibilities can make quantum physics look like a game of
tic-tac-toe. Tragic errors can easily occur because of misunderstanding or miscalculation.
There are a number of companies that promote derivatives trading through late night info-
mercials, airport hotel seminars, and on the Web as an easy path to immense wealth. It is true
that some people have become rich trading futures and options, and some people do successful-
ly speculate in these markets for a living. It is also true that many people have wiped themselves
out financially in the same way. Estimates vary, but most experts agree that the vast majority of
people who try to get rich speculating in options and futures end up poorer for the effort.
Of course, some people do succeed in becoming rich in these markets. Some people
have become rich betting on sports or playing high stakes poker, but that does not mean that
most people who do these things make a good living at it. Getting involved in derivatives
trading presents enormous risks, and it is not a game for amateurs. It is a serious and highly
complex business. While this chapter and the following exercises provide an introduction
to the basics of derivatives, they are by no means a thorough treatment of the subject. It
should be clear, though, that anyone contemplating getting financially involved in this
market should exercise extreme caution.EXERCISES 6.3
A. Futures Terminology- In each of the following scenarios, determine whether the person described would want to be long or short the
commodity in question.
a. Travis expects the price of natural gas to rise.
b. A wheat farmer wants to lock in a price to sell his harvest.
c. An electronics company wants to lock in a price for the copper it will need to buy in the future.
d. Robbie thinks that the price of gold is going to drop. - In each of the following scenarios, state whether the person described is betting that the price of the commodity in
question is going to rise or fall.