Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.
—George Soros (1930–Present)
Hungarian–American investor and philanthropist
Just an Introduction
A derivative is a securities instrument, which is a higher risk, and one that you cannot own. For instance, you own shares that you buy, but a future’s contract enables you to acquire the potential growth of its underlying security.
Let me simplify the aforementioned:
• If you bought 10,000 dollars worth of a share (Company ABC), then you own that stock.
Your risk profile is 10,000 dollars.
If the share rises by 10 percent, you have made 1,000 dollars profit.
• A derivative (e.g., A futures contract on Company ABC).
The contract is worth 10,000 dollars.
The risk of not owning the stock is a gearing of 10 times.
This means that your risk exposure is 100,000 dollars (your contract × 10).
If the share rises by 10 percent, you have made 10 percent on your risk profile of 100,000 dollars = a profit of 10,000.00 dollars.
Or, stated differently, a 100 percent profit.
Remember that the opposite is true.
If the underlying stock fell by 10 percent:
Equities would lose 1,000 dollars and have a portfolio worth of 9,000 dollars.
Futures would lose 10,000 dollars and a portfolio of zero.
In reality, the institution from whom you bought your futures would call you to add to your position (margin call), or they would close it down.
Either way, you have lost your entire portfolio.
So, the value is derived from the value of the underlying security, which can be commodities, forex, bonds, stocks, or even an index. Four most common examples of derivative instruments are forwards, futures, options, and swaps, as discussed hereunder.
OTC Traded
Type 1: Forwards
Definition: Forwards are informal contracts between two parties or individuals, where the parties agree to sell something at a future date, but at today’s set price.
Note that this instrument is private and not via an exchange, and thus does mean that there is added risk, as there are times when the parties cannot deliver and end up in the court.
Type 2: Swaps
Swaps are instruments that enable two parties to exchange cash flows, such as swapping a fixed interest rate for a variable or floating one.
For companies, the importance of swaps is to minimize the risk of vast foreign exchange rate fluctuations.
Exchanged Traded
Type 1: Futures
Definition: Futures are standardized forward contracts, which are legal agreements to buy or sell something at a set price at a predetermined time in the future.
The main difference between a forward contract and a futures contract is that the latter is traded via an exchange. As such, these are standardized contracts signed by seller and buyer via the exchange and cannot be changed once signed, that is format, sizes, and closeout are set.
It is important to note that these traded securities are settled daily, which means that, if your position is against you, the institution could close out your security.
• Trading advice: Futures are mainly used to hedge long-term portfolios or by traders taking advantage of market anomalies.
Type 2: Options
Definition: An option is part of available derivative securities, where buyers obtain the right, but not the obligation, to buy (call) or sell (put) a security at a set price (the strike price) at a specific date (exercise date).
There are two types of options, that is, call option and put option.
Option |
Explanation |
Call |
Right but not the obligation to buy something at a later date at a given price. |
Put |
Right but not the obligation to sell something at a later date at a given pre-decided price. |
• Trading advice: Use options only if your calculated price of the conversion is less than the price of the securities you are buying. For instance, if the option is on Stock A and the conversion at the exercise date is 10 for 1, calculate the total cost of the option and the expected value of the 10 stocks at exercise date.
Associated Risks
Any geared instrument, such as derivatives are risky, but are useful tools in expediting growth of a portfolio by taking advantage of anomalies. I have set out a number of these risks.
Most derivatives contracts are OTC, and thus do not concern traders. For your understanding, this means that there is often a high probability that one of the parties may not fulfill his or her side of the obligation.
• Trading advice: Only trade in exchange-listed derivatives.
Risk 2: Price
Too much focus has been placed on the complexities of derivative pricing. In fact, because a derivative is a financial contract based on an underlying security, such as a share or commodity, you should be valuing the underlying asset rather than the derivative.
• Trading advice: Find the true value of the underlying asset and then forecast its potential future trading range. This means that you have conducted fundamental research on a derivative instrument and acquired it based on price and timing using technical triggers.
Risk 3: Agency and Principal
Many exchanges around the world permit stockbrokers to trade the same instruments for their own book (principal trading) and for clients (agency trading). If the principal and agent are the same person, there may come a time when a conflict of interest occurs.
Risk 4: Systemic Market Collapse
System risk is defined as the probability of a major default causing a widespread market default across all financial markets, such as the 2007 or 2008 housing collapse.
Chapter 13 takes traders into the realm of futures trading.