What is a derivative?
Derivative is a catchall term for an instrument that is not like a stock or bond itself but rather a contract with rights to purchase or sell something of value at some point in the future. Some derivatives obligate both the buyer and seller to execute the future transaction. Others grant the option to transact to the buyer of the contract. There are many types of derivatives, but the two main ones are futures and options. The comments below are pertinent to derivatives in general.
Why you should avoid derivatives
They are not investments
It is possible and sometimes probable you could buy a derivative and never exercise the rights therein, forfeiting every penny spent. Conversely, if you sell a certain derivative to augment income, you could end up owing many times more money than you received. Something rendering no actual material ownership with the reasonable likelihood of losing all of your money (or more) is not an investment. It is irresponsible speculation.
Competitive disadvantage
Unlike stocks, where all investors can gain as a growing economy fosters rising markets, most derivatives are zero-sum games. One person’s gain is another’s loss. In the days and months after the derivative transaction, price movements of the underlying security or commodity will hurt one contract party as much as it helps the other. In each market, there are interested experts who specialize in the analysis and trading of both derivatives and the underlying items. In a zero-sum game, your chances of out trading devoted professionals are almost nil.
What you should do instead
If your interest in buying a derivative is based on a favorable view of its underlying security, ignore the derivative and buy the underlying security directly. Potential returns may not be as dramatic, but potential losses won’t be, either. Further, derivatives expire, and it is possible your favorable opinion will be proven right – but only after the derivative’s expiration date. If you bought the item directly you could still profit; with the derivative, you would have lost all.
If your interest in selling a derivative is to increase income, find such income elsewhere – or do without. If you need more income there are safer means, such as high dividend paying stocks or more aggressive bond positions. These have risks too, but nothing approaching the devastation derivatives can bring. Good investing means seeking upside potential and limiting downside risk. Derivatives bring the opposite.