Derivatives for dum­mies

Finweek English Edition - - INSIDE - BY KRISTIA VAN HEER­DEN kris­tiav@fin­week.co.za

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.

EX­AM­PLE

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.”

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