Stop Demonizing Derivatives

Judging from all the bad press that derivatives have gotten over the past two years, you'd think they were the worst thing to be unleashed upon the world since Pandora decided that one little peek inside that pretty little box she was told to never open wouldn't really hurt anyone. But if you think derivatives are solely "financial weapons of mass destruction," as Warren Buffett once put it, then you're only seeing half of the story.

Speculation vs. Hedging
It's true that derivatives give investors great power to speculate. Want to bet on a continuing rise in the price of gold or silver? Futures contracts let you control thousands of dollars' worth of precious metals while only having to put up a small fraction of its value in cash. Think a hot tech stock is going to post outlandish earnings next week? Buy a call option for just a couple bucks, and if things go right, you could have a 10-bagger before you know it.

In some cases, you have speculators on both sides of a derivatives transaction. But there's a much different reason why some people use derivatives: to hedge business risks that they have. Without derivatives, many people's lives would be a whole lot harder.

Farming and finance
The Wall Street Journal highlighted one such use earlier this week, telling how farmers hedge some of their exposure to moving prices for their crops by locking in prices by using futures contracts. Although the article focuses on the impact of financial reform on farmers' hedging practices -- and gets it wrong, according to some critics -- the article's description of how hedging works is valid.

In fact, with agricultural commodities, derivatives actually make life easier both for farmers and for food companies that need those crops. In 2008, when commodities prices were soaring, hedging strategies helped Hershey (NYSE: HSY  ) control and predict its expenses. General Mills (NYSE: GIS  ) and Kraft Foods (NYSE: KFT  ) routinely use derivatives to smooth costs of the raw materials they need to produce their products.

Other valid purposes
The demand for hedging goes way beyond the food industry. Southwest Airlines (NYSE: LUV  ) built an ingenious hedging strategy for fuel costs that helped shelter the company from steadily rising oil prices for years, giving it a competitive advantage over other airlines.

Many consumers in the Northeast do something similar to hedge their winter home heating costs. Oil companies offer fixed-price contracts to customers, guaranteeing a certain price for heating oil no matter how much the spot price may rise during the winter months.

Good news and bad news
Of course, hedging doesn't always work out for companies that use it. Until 2007, Newmont Mining (NYSE: NEM  ) and Barrick Gold (NYSE: ABX  ) used hedging strategies to lock in future prices for selling the metals they mined. But that meant they missed out on realizing the full benefit of the rise in gold prices, and Barrick ended up spending huge amounts of money to take those hedges off.

Similarly, about a decade ago, Ford Motor (NYSE: F  ) used forward purchase contracts to lock in prices of palladium, which it needed to build catalytic converters for its vehicle production. Unfortunately, it locked in at a time when palladium was hitting a peak above $1,000 per ounce. It subsequently slid below $200 before recovering to its current level around $450.

What derivative-based hedging does it allow businesses to take future uncertainty and turn it into a fixed, predictable cost. As long as the counterparties these companies do business with stay solvent, they're protected from adverse price moves.

It's in the way that you use it
Derivatives aren't inherently good or bad. When speculators use them in a way that magnifies their exposure to given markets, they can find themselves in a situation that quickly escalates beyond their control. But for others who need derivatives to hedge their risk exposure, derivatives are a vital financial tool. Any regulation that restricts derivatives without protecting their beneficial uses can only hurt an already fragile economy.

Banks have been notorious derivatives users. Morgan Housel has the latest scoop on how bank earnings are shaping up.

Fool contributor Dan Caplinger is a speed demon but stays away from pentacles. He doesn't own shares of the companies mentioned in this article. Ford Motor and Southwest Airlines are Motley Fool Stock Advisor choices. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy guarantees that no animals were harmed in the writing of this article.


Read/Post Comments (7) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 16, 2010, at 12:07 PM, tymetobail wrote:

    I knew that the Great Depression paralleled what is happening now but I needed to find where I saw the information. Below is an excerpt from Wikipedia about the Great Depression here in America. It is striking how the events then correspond to today. The only difference is the time span, the market regained its losses six months after Black Tuesday and then meandered downward until it hit bottom in 1933 about three years. Now we have roughly twelve to fifteen months which have gone by since 2008 crash placing our high in March of 2010, which would be appropriate considering how much larger and greater everything is. As they say the bigger they are the harder they fall and the longer it takes them to fall.

    http://www.gather.com/viewArticle.action?articleId=281474978...

  • Report this Comment On July 16, 2010, at 4:23 PM, SundayRider wrote:

    The problem is not that derivatives like futures and options exist. The problem is that there is no regulatory limits on them. Futures and options contracts can be created for 10 or 100 or 1000 times the volume of any existing actual commodity, stock, or bond. The trafficing in these "gambling tickets" push around the prices on the real investments so much that regular investors are all running to cash instead. They see the markets as maniplated by big money that can take a million dollars, borrow 10 million with that, and use the proceeds to buy or sell options representing the entire existence of any commodity, stock, or bond and thereby run its price up or down at will.

    The answer to this is simple, but probably won't be implemented as long as Goldman practically runs the Treasury and buys out Congressional votes. The simple answer? Regulate trading on futures and options such that there can never be more in existence (either long or short) than there are real items in existence (stocks, bonds, gold, oil, etc) Want to create 100,000 futures contracts on oil (each one is pretty big!), but there's only really enough oil in inventories to support 5,000 more? Sorry, you can only creat 5,000. Then no more, until some expire. Same with options (net of long/short positions, of course). Call options on 10,000,000 shares of XOM? Sorry there's already so many that only 10,000 more could be called. Simple fix, and you'd see the VIX go down and stay down.

  • Report this Comment On July 16, 2010, at 4:39 PM, SundayRider wrote:

    Sorry about the missed typos and other mistakes in the above. I'm usually better at checking my writing.

    I guess it gets to me that no one seems to see that manipulation via derivatives has become the same as the "stock pools" of the 1920s and early 1930s, where rich people got together to manipulate the price of a specific stock, often with the collusion of one of the stock's "market makers". These were essentially "pump and dump" operations using the tape to telegraph big buying, then dumping into the ensuing run-up. Sometimes there were lots of people who knew a pool was going on, and in the go-go days they thought it fun to "get in on the action"--which was really just fleecing other holders and buyers of the stock. But of course after the big crash no one thought that was very funny, and this led to the SEC and other regulations. How long before we get wise to how derivatives are being used to do the same thing now?

  • Report this Comment On July 18, 2010, at 1:32 PM, Tradersinfo wrote:

    Why would any investor in their right minds demonize derivatives when they give superb leverage? An average stock option contract gives 10-12-times leverage. A move of 2-3% is usually profitable for me as a buyer of options. Why all the fuss? Its credit and mortgage derivatives that are the real problem, because they are connected to debt in a way that can be dangerous for the economy.

  • Report this Comment On July 18, 2010, at 4:03 PM, mountain8 wrote:

    Dear Tradersinfo, Have fun. You are risking your own money (I hope), not mine. And probably has no effect on world trade.

    The banks are risking money that is not theirs. And their loses effect everybody.

    Futures are insurance that one can lose on without effecting anybody. In the case of farmers, it's probably a cost of doing business.

    Banks are making up instruments with no assett value and selling them for gold. When they lose... well I give you 2007-2008.

    Whoever said leverage was good.

    Sunday rider: Yes. So nice and simply, I think it bears repeating.

    "The answer to this is simple, but probably won't be implemented as long as Goldman practically runs the Treasury and buys out Congressional votes. The simple answer? Regulate trading on futures and options such that there can never be more in existence (either long or short) than there are real items in existence (stocks, bonds, gold, oil, etc) Want to create 100,000 futures contracts on oil (each one is pretty big!), but there's only really enough oil in inventories to support 5,000 more? Sorry, you can only creat 5,000. Then no more, until some expire. Same with options (net of long/short positions, of course). Call options on 10,000,000 shares of XOM? Sorry there's already so many that only 10,000 more could be called. Simple fix, and you'd see the VIX go down and stay down."

  • Report this Comment On July 18, 2010, at 4:04 PM, mountain8 wrote:

    PS. I'm not demonizing derivatives. I'm demonizing organizations that use my money to buy and sell them.

  • Report this Comment On July 19, 2010, at 2:36 PM, gddunton wrote:

    The point of a future is to lock in the price of something to receive at future date.

    The actual supply of the commodity is unknown, and a lot of the price of the contract has to do with the perceived supply and demand at the time of delivery.

    What is orange crops are destroyed by a frost, reducing supply; or OPEC cuts output reducing supply, do you then have to cancel outstanding contracts?

    By limiting the number of contracts, you are limiting the effectiveness of the market in its price discovery.

    There should be stricter leverage limits on "naked" derivatives forcing institutions to put more of their own skin in the game. This reduces a traders ability to buy "Call options on 10,000,000 shares of XOM" without having to re-allocate capitol from somewhere else.

    Hell, why not even have registered classifications of different players in the derivative markets and give different leverage ratios to each.

    Traders and other who never intend to take actual delivery have less ability to leverage, while manufacturers and others who do intend to take delivery should have more advantages terms.

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