Derivatives IV: Profits

Derivatives trading is no stranger to other trading rule: buy low and sell high. The key is to know how much others are willing to pay because it is hard to know what the real cost is.

Derivatives earnings come from two sources: agency business and trading business. Agency business makes money by finding buyers and sellers. Trading business needs to find price difference in buy and sell. Agency business is a low-risk profitable model as long as there are trades can be tapped.

Dealers' value are from their firm value because clients deal with an entity not individual. Profits from traders and sales person are actually from the firm value. Thus, contributions from individuals are negotiable and dispensable. By contrast, dealers want to setup protections to their profits by maintaining the food chain.

Besides legal sources of profits, illegal inside information is also playing a role seeing profits. Larger banks can also use overwhelming force, i.e., capital, to blast off their competitors. Fundamental and technical analysis are used to predict price movement as a tool for trading business.

Profits can be reduced due to the need of credit reserve. Credit reserve is held against contingencies --- cover liabilities, future administration cost, hedging costs. Accountants want fewer reserve while regulators want more. Mark-to-market rule acts as the rule in between. It tells how much needs to be reserved or write off.

Traders are paid handsomely. Traders work for firms with hierarchy. First tier firms are Goldman, Morgan Stanley, JP Morgan, Deutche Bank, and UBS. Contract negotiating skills are critical in getting good contracts.