A derivative is a financial security, which its value is based (derived) from an asset. For an average investor, no Nobel Laureate advises the purchase of derivatives as an instrument to be used to outperform the market. Not even Myron Scholes, the person who pretty much gave birth to the options industry, through the Black-Scholes model (1973) advises amateur investors to buy derivatives (Interview, 2018). As forecasted by the Efficient Market Hypothesis (Fama, 1970), on average, derivative investors do not beat the market. In fact, eighty-five percent of the investors who play with options lose money (Siegel, 1994). Said that, it can be argued that derivatives can be used by professionals to try to decrease the risks of a portfolio, but not to outperform the market. Two of the most popular derivatives are futures and options:
Several commodities producers can only sell their assets (e.g. corn or cotton) in a specific time of the year, i.e. the harvest period. This "illiquidity" problem makes them vulnerable to major drops in their commodities price due, for example, to an unexpected crisis. Using a futures contract, they can set up a date in the future (possibly during the harvest period) for their commodities to be sold for a pre-set price (e.g. today's corn and cotton price). In that way, commodities sellers can protect themselves against major price fluctuations (risk).
Similarly, you can buy or sell futures contracts of stocks or ETFs (like S&P 500 ETF). Investors who think that the US stock market is "too expensive" and prices will go down, can sell a contract of the S&P 500 ETF in the future at a high price. In that way, if the market indeed falls, the investor would make money because they would sell at the "high" pre-set price - outperforming the market. However, as already pointed out, markets are random and efficient enough that not even professionals can outperform the market consistently. The vast majority of the investors using futures to outperform the market fail to do so.
On the other hand, futures can be used to decrease the risk of a stock portfolio. Let's suppose you think that the market is "too high." However, you do not want to sell your stocks since this could lead to tax implications, and selling your stock now and buying again later could lead to high transactional costs. In this scenario, you could sell future contracts with part of your portfolio and maintain your other positions. Therefore, if the market does not go down, as you expected, your standard holdings will offset your futures contract losses. If the market indeed crashes you will win with the futures but loose with the holdings. In other words, the fluctuation of your investment portfolio would be smaller regardless of the market. It is important to highlight, however, that this strategy can decrease your risks but it does not necessarily increase your returns. In fact, since markets are pretty efficient, this strategy will probably decrease your long-term returns.
Investors can also buy options of selling (puts) or buying (calls) a certain asset with a pre-arranged price on a future date. Different than, futures, options contracts do not force the buyer of the contract to take any action, it only offers an option. Therefore, all strategies using futures can be emulated with options, but not the other way around. This creates a large number of investment strategies based on options. Moreover, as it is not mandatory to exercise an option, so your liability is limited. If you thought the market was going up and bought an option to buy the market (e.g. S&P 500) at the current price but the market actually goes down, you can forgo the option to buy. The problem, however, is that to buy an option contract (put or call) the investor must pay a price (premium) much higher than the price of setting up a futures contract, which goes to the seller (writer) of the option who must offer the option if the buyer decides to exercise their put/call right. Therefore, in order to beat the market by buying options, you must outperform the market plus the high price (premium) of setting up the option plus potential tax liabilities.
Moreover, in order to make money out of futures and/or options, investors need to get not only the direction of the market but also the timing correct. For example, if we are in January you sell a future/write an option for March but the market crashes only in June, you lost money compared to the simple market index (like the S&P 500). In this scenario, you sold your S&P 500 index below the market level price in March because the market went up. And when you bought the index again you lost lose money because the market crashed in June. Of course, you could have continued to sell futures/write options but you would lose money until the market really goes down. If it takes too long for the market to go down, you may run out of money before the market actually crashes, or even if you still have money left the money that you made may not be enough to offset the past losses, let alone beat the market.
The options market pricing, however, has valuable information on market risk., especially on the tail risk. The higher the volatility of the market, the higher is the price to set up an option contract, all else equal. Hence, using options, individuals can also invest in the volatility of the market. If you think that the market will become more volatile you can buy options and sell them later at a higher price. If you think that the market will become less volatile, you can write options contracts now and charge more. Consequently, it is theoretically possible to profit from options even if the market is unchanged day after day after day. In reality, however, 85% of investors lose money with options.
As well as futures, it is possible to use options to decrease risks by using calls/puts or writing contracts that go against the rest of your portfolio, probably at the cost of lower financial returns. Furthermore, even if you are willing to decrease your long-run returns in order to decrease your risks and you find a professional who manages to use derivatives successfully, they will charge fees for their service. Therefore, on average, investors will always be better off buying low-cost total market index funds than using derivatives. As Eugene Fama, the 2013 Nobel Prize winner and "the father of modern finance," states:
"Being good at active management, that’s a human-capital skill. That person is going to charge high enough fees to absorb the rents that she’s creating. Investors are always going to be just as well-off buying passive, even if they can identify who the good active managers are.”
And to look for a professional investor who outperforms the market by high enough margins to outperform their fees is not a game worth playing as we already saw in "Finding the Best Fund."
"Warren Buffett thinks that stock futures and options ought to be outlawed and I agree with him." - Peter Lynch, Legendary Wall Street Investor
"Derivatives are financial weapons of mass destruction" - Warren Buffett, For Many the Greatest Investor of All Time
"Not assuming that risk is constant of your portfolio or a 60 [% stocks] / 40 [% bonds] or whatever strategy you have would be optimal each period of time is [a good model]." - Myron Scholes, The 1997 Nobel Prize Winner
- Black, Fischer and Scholes, Myron (1973). "The Pricing of Options and Corporate Liabilities". Journal of Political Economy. 81 (3): 637–654.
- Fama, Eugene (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, vol. 25(2), pages 383-417, May.
- Siegel, Jeremy (1994). Stocks for the long run: the definitive guide to financial market returns and long-term investment strategies. New York: McGraw-Hill.
- Myron S. Scholes in "In Pursuit of the Perfect Portfolio" by MIT Laboratory for Financial Engineering (2018)