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  • A Confusing Derivative is a Good Derivative 1 comment
    Nov 5, 2009 6:31 PM

     I have been torn between the two sides of the derivatives argument, as a huge incentive gap was present between the creators (traders, Wall Street, etc.) and the money engine (the public).  On one hand, the public was in an uproar about how confusing and limited their use of the product was when their money was actually used as fuel to derive these financial monsters.  On the other, those that know how to use them could become insanely wealthy with little repercussion from being wrong.  The risk/reward balance was obviously off-kilter.  But I soon got to thinking that all the 'bad' derivatives aside, it makes perfect sense why such a product should be inherently complicated.

    I kept tossing the ideas back and forth formulating arguments, counter-arguments and counter-counter-arguments within my head; until I framed it into a different light...

    To illustrate why the business of derivatives must inherently be confusing and hard to grasp at first glance, I conjured up a good old fashion compare and contrast.  The two preliminary thoughts center around that of barrier to entry and knowing your work.

    A derivative being easily explainable is equivalent to your open heart surgery being performed by me

    Reasoning:  While the essence of both instruments and processes can be easily grasped (Derivative:  It allows you to make money by betting on the direction of the stock / Open Heart Surgery:  Any surgery where the chest is opened and surgery is performed on the heart muscle, valves, arteries, or other heart structures), the more in-depth and true understanding of how to perform the process is time lagged.  What this means is basically that the time to truly understand and be able to go out on your own and trade derivatives or perform open heart surgery, takes years to do.  If everyone could successfully pick up a scalpel and slice and dice a patient, there would be no need for nearly a decade of schooling, hundreds of thousands of dollars worth of investment and the paying of high salaries to surgeons.  It would be another blue collar job (not intending to offend those jobs at all).  The same is true with derivatives.  If I could explain so intricately and detailed the characteristics of derivatives in one sitting to my mother, and she could truly understand it...the last 7 years of my life spent trading and growing as an investor just went kaput.  Some Joe Blow could just up and walk off the street and take my job.  The complexity keeps a higher barrier to entry, therefore making the profession much more coveted by the masses due to its difficulty, time-intensity and tolerance for risk requirements.

    Learning what a derivative is, is like trying to get into a (sober) woman's pants

    Reasoning:  I apologize for isolating the women from a true understanding of this point, but all guys know that in order to honestly believe that you are deserving of rounding the four bases you must put in the time.  Day-after-day you must coax your woman; berate her with flowers, take her out to dinner and hang her around your arm, showing her off to the public.  You must establish a relationship with your woman, learn how she works, what makes her happy and most of all what makes her tick.  That is no different from the derivative market.  You must court your derivative, studying its intricate details and movements for hours on end.  You learn how it moves, how you have to react to its movements and why the investment vehicle trades as it does.  Jump in too soon fellas, and well you won't just get a slap on the cheek, you'll get a smack in the pocket book.  Derivatives are complex, yes, they cannot be learned simply from a one time sit down.  They can, however; be learned quite well over extended periods of time.  Like a woman, what you get out is all about what you put into it.

    Derivatives are complex, investment vehicles that allow investors and traders to maximize profits while hopefully minimizing risk.  It is a tricky topic to say the least, as there is corruption and greed intermingled with good and honest work.  But it is clear that after being a normal person and wandering through house and home with many others, a shroud of ignorance clouds people's minds into thinking whatever they cannot understand as unfair and evil.  Some products should be outlawed, some should not.

    The drawback in all of this is when financiers create products that there is no telling how they will react given the exacerbation of profit-making by others.  CDS and MBS served a noble purpose until fear and greed stepped into the picture, and well it can be said that fear and greed are never far behind a good idea. 

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  • Tom Au, CFA
    , contributor
    Comments (6879) | Send Message
    "The fisherman made the water muddy,
    That's how he hooked the trout."


    5 Nov 2009, 06:49 PM Reply Like
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