Derivatives for dummies
The investment world can be very simple. A diversified portfolio invested over a long period will probably grow your investment. In the unlikely event that your entire portfolio is made up of companies that fail, you’ll lose your investment. Other assets, like your cash savings, your house and your spouse’s assets will remain firmly intact. How is it, then, that people lose everything by playing the stock market?
Very often derivative products are to blame. While many investors use derivative products to hedge against losses, these products can also be used to gamble on market and price movements. The true nature and the risks involved in these products are often misunderstood, which can lead to investors losing much more than they initially invested.
WHAT ARE DERIVATIVE PRODUCTS?
“If you ask 10 different asset managers or investors what a derivative is, you are more than likely going to receive just as many answers,” jokes Mabyanine Phiri, portfolio associate at ACM Gold. Considering the different derivative products available on the market, he is not wrong.
In simple terms, derivatives are contracts for payment between two parties. The value of the contract is derived from the value of other assets, indices or currencies. Unlike a normal investment, however, the holder of the contract does not always own the assets, and can merely own a contract to purchase or sell the underlying asset to the other party at a set price at a future date. A derivative is therefore a bet that the price of an asset will go up or down some time in the future.
In the derivatives market, however, there are no participation trophies. It can be a brutal zero-sum game with a clear winner and loser at the conclusion of each contract.
HOW DO DERIVATIVES WORK?
Andrew Kinsey is the head of research and product design at GT247.com, an
online platform for trading derivatives. He explains that the original purpose of derivative instruments was to lock in future prices in the agricultural sector. First utilised in the 18th century, the Dutch used futures contracts – quite romantically – for selling tulip bulbs. The use of derivatives extended beyond agriculture in the Seventies to include equities, interest rates and commodities.
“Derivatives can be privately negotiated over-the-counter or traded on organised exchanges such as JSE. The JSE trades derivative products mostly on the equity derivatives market, currency derivative market, commodity derivative market and on the interest rate market. Futures contracts, forward contracts, options and swaps are some of the most common types of derivatives,” says Phiri.
Joanne is a chicken farmer. The current market price for whole chickens is R30 per chicken, but Joanne expects the price will go down in the near future due to an oversupply of cheap chickens from Brazil. She enters into a contract with her biggest client, Checkers. She agrees to sell her 5 000 chickens to Checkers at the current market price of R30 per chicken. If Joanne is correct and the price of chicken comes down to R25 per chicken, Checkers still has to buy 5 000 chickens from Joanne for R30 apiece. Joanne avoided making a loss of R5 per chicken by entering into the contract. If Joanne is wrong and the price per chicken goes up to R35 a chicken, however, Checkers wins by getting a discount of R5 per chicken while Joanne loses out on an additional R5 profit.
In this example, Joanne used the derivative contract to hedge against future losses while Checkers used the contract to hedge against possible price increases. Derivative contracts are used in much the same way by individual and institutional investors to hedge against future losses in equities.
THE LOSING GAME
Today, however, the derivative market also includes investors who have no vested interest in the production or consumption of the underlying assets. These investors become intermediaries between the producer and the buyer by speculating on the future price of goods.
“Problems arise when you get into speculation,” explains Kinsley. “You enter into a contract in which there are no underlying goods. People can make a lot of money speculating, but they also lose an enormous amount of money.”
If, for example, you enter into a de- rivatives contract, trading on the future price of Joanne’s chickens, you become an intermediary between Joanne and Checkers. Joanne expects that the price of chickens will go down to R25 within the next six months. You enter into a contract with Joanne to buy her chickens at the current price of R30 apiece for the next six months because you believe that the price of chickens will rise to R32.50 in that time.
As an intermediary, you do not own a single chicken, only a contract with Joanne. If you are correct and the price of chickens rises to R32.50 within the six months, you make a nice profit of R2.50 per chicken until the contract expires. If, however, Joanne is correct, you are in trouble. You still have to buy the chickens from Joanne at R30 each, but sell them to Checkers at R25. You took a gamble on the future price of chicken and lost R5 per chicken. If you took out a contract for three chickens, you’ll probably survive the setback. If, on the other hand, all your savings went into the gamble, you are in trouble (and so is your spouse’s car).
MARGIN CALL: IT’S A THING
In addition to the above examples, derivatives can also be traded on margins. This is when you only pay a percentage of the value of the underlying asset for the contract – a great way to gain exposure to the market for less capital, but risky when you overextend.
“Let’s say you buy one share of Anglo at R250. We say we want 10% margin, so instead of R250, we ask for R25. We buy the underlying share, but then the price goes down to R200.
“Because you only put up 10%, you have to pay in R5 instead of R50. You need to put in additional margin. The problem arises when, instead of buying one, you spend your entire budget to buy 10. What happens if the share price goes down to R45? Where are you going to find the additional money?”
Phiri warns novice investors to think twice before trading derivatives. “One of the main risks [in trading derivatives] is the possibility of losing more money than you started with. Investors need to understand the risks involved in taking leveraged positions. No-one should trade derivatives unless they are experienced traders with the knowledge, risk control and financial capacity to trade such instruments. Derivatives traders require a high appetite for risk, time to watch the markets and an expert knowledge of the markets and trading process.”