Futures & Options: Jackpots or ticking time bombs?

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. 

For example, if the rate of gold increases, then the rate of a gold futures contract in the Multi Commodity Exchange (MCX) will also increase. Here, gold is the underlying asset for the gold futures contract.

Likewise, the Nifty 50 is the underlying asset for the Nifty futures contract. In India, the two popular forms of derivatives are futures and options (F&Os).

What are futures?

Futures are derivative contracts in which both the buyers and the sellers have an obligation to buy or sell an underlying asset at a predetermined price on a future date, decided today. 

If a trader thinks the price of natural gas will increase in the next three months, he can buy a natural gas futures contract today. If his prediction is right, he can gain considerable profit. But if his prediction fails, he would incur an unlimited loss.

What are options?

In an options contract, buyers have the right, but not an obligation, to buy an underlying asset via the call option, or have the right to sell an underlying asset via the put option at a specified price before a certain date. It’s because of this flexibility, investors think options are safer.

In fact, there is a popular, saying — “If you want to trade options, there are more options, but if you want to trade futures, there is no future [for the trader].” Though options have more options, they are highly risky, to the extent that your capital would erode to zero.

Options buyers presume maximum loss as only the premium paid, as in theory. They are not aware that the premium loses value owing to the passage of time (Option Greek Theta). 

The premium amount is similar to an ice cream that melts minute by minute owing to the decay in time value.
Are they assets?

Retail investors trade in F&Os under the assumption of diversification. But F&Os are not long-term assets; after the expiry of the contract, you cannot enjoy the possession of the underlying asset. Therefore, unlike equities, there is no question of growth in the value of the derivative assets in the long run.

Tool for hedging

Derivatives are a helpful tool for those informed traders who use them as a hedging strategy (to mitigate losses), whereas most retail investors enter the derivatives market without proper skill and knowledge and end up speculating in the market. If you gamble in the derivatives market without awareness or knowledge, there is a risk of losing your entire capital.

Leverage risk

One of the main risks of derivatives is the leverage facility, which allows traders to take larger positions with relatively small capital, unlike in spot markets. 

Magnify losses

Traders are attracted by the fact that leverage can magnify profits, but they are not aware that leverage can also magnify losses. Even a small negative movement in the price of the underlying asset can cause huge unbearable/irrecoverable losses.

So, beware, greed brings grief. Derivatives are not certain jackpots to get excited and invest in. They can also be ticking time bombs. In over 90% of cases, they are time bombs with potential to ruin an entire life’s savings in the blink of an eye.

(The writer is an NISM & CRISIL-certified Wealth Manager)

Published on May 19, 2025