Warren Buffett, probably the world's most famous investor, called derivatives the financial equivalent of 'weapons of mass destruction'. He wasn't bemoaning long-established simple derivatives such as money or credit cards, but sophisticated financial derivatives.

In general, derivatives are used as insurance - for example, a pension fund may want to hedge its portfolio, so it would buy an index future. This hedging has an associated cost, but there's usually a physical position underlying the trade so the derivative holder loses on one part of the hedge and makes on the other. For a company that wants to hedge $100 million in currency, the cost is very small, because the risk is tiny and the demand and supply is so huge.

It's this efficiency that makes derivatives such a huge market. The trouble starts when hundreds of millions of dollars of derivatives get traded and there's no counterbalancing hedge. This is the realm of the speculator and rogue trader (read the original rogue trader, Nick Leeson, in every issue of InsideEdge magazine).

Bit like a mortgage
Because the cost of taking massive positions is so cheap, someone with unfettered access can build up mighty positions very quickly. In this way, a rogue trader in a bank can easily build up positions big enough to bring down the roof. In much the same way, a private speculator can lose his shirt overnight.

This explosive quality comes from leverage. Leverage - or gearing - means that for a little money down you can buy and sell a multiple of it. For example, in foreign exchange, a speculator can have 100 times leverage, which means with £10,000 down, he can trade £1 million of currency. So with a log position in the pound, he can double his money if the exchange rate moves a mere 1%. This is fantastic news if the price goes up 5% in a month, as he will make £50,000, but if the price moves 1% against him, he will lose the lot. In equities, a speculator can easily get ten times leverage so with £10,000, he can trade £100,000 of shares.

Margin isn't such a problem if you're selling $100 million and the dollar invoices for your product are already sent off. If the price moves against your position, it's not a problem to send more money to your broker. However, if you're a speculator, a request to top up your account to cover your position is often enough to force you to close your position - or 'bomb out' - and is the way most speculators lose their money.

Without leverage, derivatives would lose their usefulness and their dangerous qualities. Whether you trade in Spread betting positions, options or covered warrants, the situation is the same: you can expose yourself to more risk for the prospect of more return. Leverage should be about keeping costs low, but it's often more about keeping risk/reward high.

The largest derivatives traded by private investors are the S&P E-mini futures contract, which will trade approximately nine trillion dollars in the next 12 months on the Chicago Mercantile Exchange (CME). Based on this fact alone, we can safely say that the E-mini is a huge market.

Working for the Yankee collar
A futures contract is a bet on the future price of a thing - in this case, the level of the S&P 500 stock index, which represents the mightiest enterprises in the US economy. The S&P 500 is a basket of stocks and the S&P E-mini is a derivatives contract based on it.

Launched in September 1997, the first E-mini was introduced as a smaller version of the popular S&P 500, whose underlying value had reached $250,000 per contract due to the unstoppable bull market.

The E-mini is a $50 billion daily yank on the collar of Uncle Sam's biggest stocks. Its aim is to lower the barrier to entry of trading an S&P future: the E-mini is a mere 20% of the size in terms of underlying value and so brings down the underlying capital value to around $50,000 - hence 'mini'. When the S&P rises by one point, the E-mini holder is $50 better or worse off depending on whether he is long or short.

As a fully electronically traded instrument, it attracts not only institution players who find it useful for fine-tuning portfolios, but also speculators, who find it easier to participate at this lower threshold. The E-mini runs alongside the open outcry contract - people shouting and waving at each other trade the big old S&P contract, while the E-mini transacts silently through an electronic order book. The E-mini is a contract born for the internet, and online day traders have flocked to it.

In today's stock markets, it's the future that drives the present. When the future S&P contract price moves, the index is soon to follow. More and more, the future contract for the S&P drives the present index price and the underlying stock, rather than the other way around.

All markets are linked, and the biggest markets push the others around. Prices are brought together by arbitrage, where players buy something cheaper in one market and sell it more expensively across the street, ocean or network. This basic idea reaches out so that stocks, currencies, bonds and commodities are linked across markets by arbitrage and derivative 'hedges'. This is how action in a futures contract drives the price of the underlying shares of an index. This is how derivatives drive the price of real things like cheese.

The cost to wield a day trade of a $50,000 S&P E-mini is less than $20 a go. Coupled with ten times leverage, almost anyone can place six-figure bets on the perturbations of the US economy, and they can do it from anywhere on the internet.

Unlike stock traders, who tend to stick to the long side of the game, futures traders play the short and long side equally. So while equity trading wilted during the bear run, E-mini trading continued its explosive growth of 200% a year compound. However, you have to have balls like a bull to believe this risky game is a good thing.

The populace has access to the vitals of the US economy via a derivative of a derivative and is placing a million $50,000 bets a day on its smallest twitches. It doesn't take much musing to imagine a massive financial accident just waiting to happen; yet it hasn't occurred yet. Private US speculators, with their unfathomable charts and addiction to risk, are pulling derivatives into the mainstream, and we in the UK should be sitting up and taking note.

Last year the S&P E-mini contract broke the one million contracts per day mark, and it's not hard to see why. The cost of trading is minute, with the spread one tick wide or $12.50 per contract and commissions of less than $5 a round trip. Put another way, a private investor can trade an E-mini contract for a cost of 0.035%, leaving them in profit from a half point move in an index of 1,000 points. Comparing this to the ludicrous spreads a UK equity day trader must vault and it would already seem that an E-mini is an irresistible alternative.

Who's the fool?
Some brokers offer margin accounts as low as 5%, although it may require a clinically insane speculator to operate on such massive leverage. Twenty times leverage is very much a mixed blessing, yet for a speculator with a plan, this level of credit opens up all sorts of speculative horizons.

Another attraction of the E-mini is the ability to get in and out of the contract, in size, at will, without the risk of a sudden catastrophic gap. The E-mini is practically a gap-free contract, and with such tiny costs, there's no call to leave positions open overnight. The general liquidity also enables day traders to scalp tiny moves and, while it might appear strange to capture $12.50 of profit using $50,000 of capital at risk, an ultra-liquid market makes this possible.

This contract is open around the clock and only closes for a short time. Training companies claim you only need to catch ten points in a day to make $10,000 a month from the comfort of your own home. However, this is a massive game where you play against serious talent. It's like playing poker in Vegas - if you can't see the fool at the table, it's you.

While the possibility of a wipeout from being over-leveraged is a real possibility, it's the costs of trading that on the whole destroys the capital of a speculator. It's the erosion of untiring costs from churning their capital that chisels them away. The E-mini is about the cheapest instrument to trade going, so in this sense it's the best. While the uninitiated can easily slip into over-betting, the E-mini is still a superb tool for speculation.

While speculation is a bit of a dirty word in Europe, it still remains the oil that keeps the markets efficient.

Comparing the UK for an equivalent day trader opportunity - or, for that matter index-tracking, tool - it quickly becomes apparent that we're living in the Stone Age. Only LIFFE's FTSE 100 future contract, which weighs in at a similar $60,000 of underlying value, comes anywhere near, mustering a 50,000 contract volume but a spread four times as wide. What's more, access to such instruments is definitely restricted to the top shelf.

Derivatives are now the dominant type of tradable financial instrument, leaving stocks and shares well behind in terms of dollar amounts traded. They can be as safe as houses or as risky as Russian roulette. In the end, a speculator just wants volatility and good execution. As derivatives begin to spread further into the private investor space, they will inevitably become more popular. Just remember: it's the leverage that gets you.