Is derivative trading hard?
Education / Trading and Investing / Math
Some derivatives can become easily accessed and traded as securities in the listed market. Recent examples are the bets some investors took by buying (short-dated) call options on so-called meme stocks. In this context, the motivation was to express the leveraged trade idea in the most capital-efficient way. Hence, its not required to have a thorough understanding of the underlying derivatives pricing theory. Apart from determining whether the respective option premium justified the potential investment to payout ratio.
However, more complex hedge analyses or pricing of highly path-dependent derivatives require a much more sophisticated understanding of the underlying option pricing theory. This knowledge is also necessary to determine which pricing model is best suited to assess the fair value of a respective payout since simple Black-Scholes-Merton diffusion approaches are not always justified.
Derivatives can be employed as directional instruments/bets or vehicles to hedge existing positions, due to their embedded leverage, the exact notional and respective payouts must be carefully analyzed and monitored. Moreover, the trade entry and exit costs due to liquidity constraints can be higher than for the individual source instruments. However, ultimately, derivatives are just leveraged investments of their source instruments or individual payouts. In that sense, they carry more risk for a potentially higher return. This risk-reward relationship implies that if the original investment thesis or hedge analysis becomes executed correctly. As a result, it is possible to make money from trading derivatives and potentially earn a higher risk-adjusted return.
Derivatives are complex and risky investments that may not be suitable for all investors.
Moreover, derivatives are financial instruments typically expressing a leveraged view on an underlying security. Or trade idea.
Therefore, unless purely used for hedging purposes, derivatives trading can be highly profitable if the investment thesis works out. However, given their leveraged nature, derivatives also embed higher risk for the potential higher return. Trading derivatives can be a good and cost-effective way to hedge existing portfolio risk/exposure, or express a trade idea.
Derivatives can trade in listed or OTC format. Whereby both are often cleared in order to mitigate counterparty default risk.
Since derivatives are often non-linear instruments. As a result, exposure may change quickly, which makes diligent risk management and scenario analysis even more important.
Moreover, the purpose of this book is to provide the theoretical minimum for trading derivatives in various asset. Furthermore, product classes from the perspective of a trader or risk manager. While a trader does not require the same level of technical knowledge as a quant. Moreover, it is essential to understand model risk and behavior when pricing and risk managing derivatives.
The same is true when applying hedging techniques, which are often not perfect and may themselves introduce additional risk. Finally, given the stringent monitoring of capital requirements, the understanding of valuation adjustments, and their impact on the pricing and the derivatives lifecycle is a topic that is impossible to ignore.https://read.amazon.com/kp/card?preview=inline&linkCode=kpd&ref_=k4w_oembed_bAVXa3y8BMdLMn&asin=0578548658&tag=kpembed-20
Mika Kastenholz serves as a Managing Director and Head of Structured Macro at Credit Suisse.
Mika’s broad range of knowledge and experience covers trading (complex) derivatives in several asset classes. Systematic investing, and the ever-evolving tech landscape in finance. This book is based on a series of lectures Mika held at the Swiss Federal Institute of Technology in Zurich (ETHZ). And aims to serve as a bridge between industrial practice and academia.
Is derivative trading hard?
