The weird and wonderful world of derivatives trading

For many traders, dealing in derivatives is out of the question — because these financial instruments can be so complex and risky.

Derivatives are securities (or tradable financial assets, which include banknotes and shares) whose prices are derived from an underlying asset, hence the name.

Derivatives can track almost any measurable item. Value can be derived from an asset, a specific event or outcome — be it politics, economic expectations or commodities.

For instance, contracts for differences — discussed last week — are a form of derivative, because the value of the contract is derived from the underlying share.

Most derivatives track familiar assets such as shares, bonds and exchange-traded funds. Institutional investors and companies looking to expand to new regions can use derivatives to manage risk.

The JSE has a derivatives market. There are three types of derivatives:

Futures contracts — referred to simply as futures. These are for investors who’d like to hedge their investment. A futures contract is an agreement between two parties to exchange an asset at a specific price some time in the future. The hope is to gain some benefit from the possible movement of a stock.

These financial instruments are geared — meaning investors can put in a small initial margin and make higher profits.

Single-stock futures are popular in South Africa. They allow investors to lock in the price of a share so they can pay the same price for it in the future. For example, to manage risk, investor A might want shares in Pick n Pay at the current price, but will only buy them in a year’s time.

This helps investors plan for unforeseen circumstances. Speculators also enter futures contracts.

Forward contracts — referred to as forwards. These are also used by investors to hedge. The difference between forwards and futures is that forwards are traded over the counter, while futures are traded on an exchange.

Options. These instruments are also much like futures — but traders have the option to pull out of the contract should they wish to do so.

There are two types of options: call options and put options.

With call options, traders have the option to buy an asset on a specific date. Think of it as locking in an investment that you intend to acquire in future — like paying a deposit for a house.

Put options, however, allow traders to sell an asset on a particular date, giving investors a way of insuring an asset against negative price movements.

Options are slightly different from other derivatives when it comes to the cost. Anyone who holds options will pay a premium for that benefit. The upside of options, though, is that you’re protected by the premium, so it functions as a riskmanagement tool.

A popular type of option is a warrant. Warrants are issued by companies in the same way that they issue shares. They aren’t listed on the derivatives market, but on the equities market, and can be bought through a warrants broker.

With derivatives — excluding options — there are expiry dates on the contracts, which you need to be aware of, because you will either need to settle the contract in cash on the due date (which might mean you lose money), or buy another futures contract.

These are complex products and it is easy for people who don’t understand them to be taken for a ride by con artists.