Derivatives add risks shares do not have - assignment, margin calls, unlimited short losses - plus higher trading costs and tax treatment that differs by product and country.
13 min read · Level 5
The feature of derivatives I respect most is that they force every risk to become a cash question with a deadline. That is useful for professionals who manage it deliberately, and brutal for individuals who do not. A position that can be closed for you by someone else at a moment you did not choose is a different kind of risk from anything in an ordinary portfolio.
The main risks:
Risk What happens Short option loss a sold call has no fixed maximum loss Assignment a sold option can be exercised against you, sometimes early Margin calls losses on futures and short options require more cash immediately Forced closure the broker can close positions if margin is not met Liquidity wide bid-ask spreads, especially on less-traded contracts Product risk leveraged retail products may carry extra counterparty risk
A sold call at strike 105, premium 3, shows how unlimited loss works:
Share at expiry Obligation Net result 110 -500 -200 150 -4,500 -4,200 200 -9,500 -9,200
Costs add up quickly. Opening and closing a position crosses the spread twice. On an option with a 0.40 spread and 100-share contracts, a round trip costs around 40 per contract in spread alone, plus commissions and fees.
Tax treatment of derivatives differs by jurisdiction and by contract type. Gains may be taxed as short-term or long-term capital gains, as ordinary income, or under special rules for particular listed contracts; hedging positions can affect how gains on the underlying shares are treated; some leveraged retail products are treated differently from listed options.
Because derivatives failures tend to be sudden. A share falls gradually and you can decide what to do. A margin call gives you a deadline, and a forced closure can crystallise a loss at the worst moment.
Costs matter more for short-term trading. Paying a spread worth several percent of the premium on every trade is a large handicap for a strategy that trades often.
And tax treatment can change the after-tax result materially, so the same pre-tax gain can be worth different amounts depending on the contract and where you live.
This is educational information, not tax or accounting advice. Rules differ by country and change — get advice from a qualified professional in your jurisdiction before acting.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Sources: U.S. IRS - official tax information; UK Government - Capital Gains Tax guidance; U.S. CFTC - Commodity Futures Trading Commission; FINRA - investor information
A futures position through a margin call. An investor holds one contract worth 50,000 with 5,000 initial margin and a 4,000 maintenance level.
Day Price move Loss Account Status 1 -1% -500 4,500 above maintenance 2 -2% -1,000 3,500 margin call: top up to 5,000
The investor must add 1,500 immediately. They cannot, and the broker closes the position at the next price. Two more days of recovery would have erased the loss, but the position no longer exists. The investor lost 1,500 of their 5,000 - 30% - on a 3% cumulative move.
Assuming you can wait out a bad move on a leveraged derivative the way you might with a share. Margin rules decide how long you can hold a losing position, not your patience.
If a position has no fixed loss limit, either hedge it or do not open it.
Keep enough readily available to meet margin requirements after a large adverse move, not just the initial margin.
Add spread on entry and exit plus commissions, and compare to the expected gain.
Ask how gains and losses on this contract type are taxed in your jurisdiction and whether hedging affects your other holdings.
Before trading any derivative, and whenever a strategy involves selling options or using margin.
Do not rely on general tax descriptions for your own filings; the rules vary by country, contract and account type.
In February 2018 several exchange-traded products that bet on low market volatility lost most of their value in a single trading session when volatility spiked, leading to at least one product being terminated. The event was widely covered in financial press and discussed in regulator commentary on complex products.
Products built on derivatives can fail suddenly and completely, even when packaged as ordinary exchange-traded securities.
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