The risks associated with derivatives are very different to those incurred in the cash markets. When buying a share for example - a long position - your maximum possible loss is the amount you originally paid for it.
Derivatives, on the other hand, exhibit a lot of different risk profiles. Some provide limited risk and unlimited upside potential.
For example, the risk of loss with a derivative contract which confers a right to buy a particular asset at a particular price is limited to the amount you have paid to hold that right. However, profit potential is unlimited.
Others display risk characteristics in which while your potential gain is limited, your losses are potentially unlimited.
For example, if you sell a derivative contract which confers the right to buy a particular asset at a particular price, your profit is limited to the amount you receive for conferring that right, but, because you have to deliver that asset to the counterparty at expiry of the contract, your potential loss is unlimited.
Because of the wide range of risk profiles which derivative contracts exhibit, it is vital that you have a clear understanding of the risk/return characteristics of any derivative strategy before you execute it.
Leverage
Apart from the structure of the instrument itself, the source of a lot of the risk associated with derivative contracts stems from the fact that they are leveraged contracts.
Derivative products are said to be ‘leveraged’ because only a proportion of their total market exposure needs to be paid to open and maintain a position. This percentage of the total is called a ‘margin’ in futures markets; and a ‘premium’ in options markets. In this context, ‘leverage’ is the word used in all English-speaking derivative markets.
Because of leverage your market exposure with derivative contracts can be several times the cash you have placed on deposit as "margin" for the trade, or paid in the form of a premium.
Leverage, of course, can work both in your favour and against you. A derivative which gives you a market exposure of 10 times the funds placed on deposit is excellent if prices are moving in your favour, but not so good if they are moving against you, as losses will mount up very rapidly.
