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Derivatives Markets

The Smart Profits Report: Issue # 254
Thursday, October 27, 2005

Derivatives Markets: “Textbook” Trades Don’t Always Win
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Last week, I spoke to economics students at Rollins College, in Winter Park, Florida, my alma mater. The topic was the derivatives markets - those that deal with futures and options. The professor who invited me was Dr. Harry Kypraios - the same teacher who taught me some 23 years ago.

I tried to think back to my first exposure to derivatives, and how much I hated the topic. I’m sure many of you have kids or grandkids who are in college right now, wishing they could just make it through courses in derivatives, calculus, statistics, etc. These are not high on the favorites list for many of us. I tried to be humorous in my talk, exposing the group to the “real-life” experiences of trading derivatives, versus learning about them.

In the real world, I lectured, derivatives trading is much more complex than theory. There are a host of factors that the textbooks just don’t cover. For example, they don’t mention market makers, news events, market manipulation, uneven bid/ask spreads, bad brokers, bad traders, and contra-accounts that have been the downfall of many trading houses like Barings. Textbooks don’t mention that the derivatives markets are run by a sort of “brotherhood” of traders and exchanges whose motivation is profits… and not advancing education.

Then I explained the importance of cynicism… I admit, it may have been callus of me to reveal some truths about investing at such an early and tender age.

Getting Sacked By An “Enron,” Then Back for More?

Since I received my graduate and postgraduate degrees, I have become much more cynical, too cynical, as my significant other constantly reminds me. I remind her that my cynicism is borne of experience, not from reading too much.

Cynicism is, in my opinion, one of the strongest tools an investor should possess. The market is not made up of cute and cuddly textbook writers who were comfy in their professorial responsibilities before deciding to cave into the pressures of their department chairs and write college textbooks. Rather, it is made up of profit-hungry specialists whose aim is to part you from your money.

Derivatives Markets: Bastions of Wealth

The derivatives markets as well as the other markets are the foremost bastions of the greatest legal transfer of wealth in the world today. Each day you make bets on what you think are wholesome and legitimate enterprises. Then comes the reality - Refco, Worldcom, Enron, Hedge Funds, Mutual Fund kickbacks, non-existent corporate governance. We shake our collective heads, and the next day we start again, blindly pledging our trust to a system that we know is stacked against us.

Cynical? You bet I am. Contrarian? Yes sir, that’s me. It has served me and my readers well to not believe everything we read or hear. I don’t regret a moment of my education, from boarding school in England, to university in the States. What I do regret is the lack of textbook writers who write from experience, with candor and fortitude, and tell it like is… and not like it should be.

Good Trading,

Karim

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Today’s Smart Profits Cribsheet

  • While textbooks don’t beat experience, there is an options book I highly recommend. And you can get it for free… Characteristics and Risks of Standard Options is a valuable title - and you can’t beat the price. To get your copy, just call 888.OPTIONS, or write to the Options Clearing Corporation, One North Wacker Dr., Suite 500, Chicago, IL 60606.
  • Check out the Smart Profits Glossary for definitions of words like “derivatives” or “market maker” found in today’s article.

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