In This Chapter
Considering futures
Deciding on warrants
Recognising your options, your choices, and your responsibilities
I'm going to start this Chapter by saying that derivatives are probably the deepest water you're ever likely to get into as an amateur investor. No, actually, I'm going to go even further than that. Don't get into derivatives at all until you're good and ready, because they can really be far too dangerous for a beginner. A wrongly placed futures contract can leave you worse off than when you started. You can indeed lose much more than your original stake with some kinds of derivatives, and no-one wants to see that happening.
But the dangerous nature of derivatives doesn't mean that you don't need to understand at least a little bit about them. The more you get interested in the commodities market (oil, gold, copper, wheat, and all that), the more often you're going to come across mentions of derivatives in the newspapers, because derivatives really are what drive the raw materials industry. And the more sophisticated hedge funds (Chapter 15 deals with these) get in the next few years, the more likely you are to find yourself reading articles that demand at least a limited amount of knowledge about this peculiar business. So I wouldn't be doing my job if I didn't at least give you a feel for what they are.
Derivative is rather a broad piece of terminology that covers an awful lot of ground, so I need to simplify things a bit. A derivative is a financial product that's derived from a share, or maybe a commodity, or maybe even an index of some sort. And a derivative is all about managing financial risk. You're unlikely to come across derivatives in the course of your normal life – except for a type called options (see the 'Options' section later in this chapter). If you work for a fast-growing company that has more prospects than cash, you may well be offered these. Back in the crazy 1990s, many companies paid their key personnel partly in stock options that made them rich if everything worked out well for the company.
Some stock options did do well, of course, and some didn't. Some options schemes evolved into employee share ownership schemes, although with slight differences. But full-on options mania may very well strike again one day, when everyone's feeling a bit more optimistic about the future. So I think you'll agree that knowing at least a little bit about derivatives does no harm.
Futures are really quite a simple concept to grasp, once you've got a few basics sorted out. A properly used futures contract is a thoroughly useful and valuable thing, which can help to protect the interests of just about everyone whenever people are dealing with a situation in which nobody really knows what the future will bring. Used wisely, futures can even out the bumps when the going gets rough. But futures can also be used in a different, more dangerous way – which is where they get their bad reputation. If you set out to use them speculatively, rather than for safety, they can make you very rich, or very poor, in a remarkably short space of time.
I suppose I could always start with the formal explanation. I could tell you that a futures contract is an agreement between two parties to exchange a specific type of goods, in a specific quantity, and at a specific time in the future. And that the contract they draw up between them is set up in such a way that either of them can back out of it (with a suitable cash adjustment), or sell it on to somebody else, or just go through with the deal as planned. But the chances are that you wouldn't find that very easy to understand.
So, rather than heading straight into the complicated nuts and bolts of a futures strategy, I'm going to start this section with a fictional analogy that I hope will give you a rough idea of how the principle of futures trading works. Then I'm going to translate this analogy into how things operate in the real world. Ready?
Say I'm a ticket tout and I've got a stack of £100 tickets to watch the quarter-finals of the European Championship in two months' time. You're interested in buying one of them, because you reckon a 75 per cent chance exists that your national team's playing in the match.
But neither of us knows what the street value of a ticket for the match is likely to be in two months' time. What we probably do know is that, if the national squad's playing, the ticket will be worth the £100 I'm asking for it, and maybe more. But if our boys get knocked out during the qualifiers, the chances of anybody wanting to buy the tickets are sharply reduced. Their value may quite possibly fall sharply. Indeed, maybe I won't manage to sell any of my tickets at all.
I can, of course, sell you the ticket now for £100 and say take it or leave it. But that doesn't really work for you. In an ideal world, you want to wait until the qualifying rounds are over, because if the national squad gets knocked out you might decide to walk away and not buy the ticket at all.
But those aren't the terms I'm offering. I can't afford to let you wait that long, because then I may end up with nothing at all. So I need to reach a deal with you whereby we both get roughly what we want. And I also promise you to deliver the ticket to you on the day of the match. (Yes, I know that's a bit improbable, but bear with me.)
In effect, as far as you're concerned, the value of my £100 ticket is £75 right now, because the national team has a 25 per cent chance of being knocked out. So, by committing yourself to buying my ticket now for £75, you're taking a gamble on our boys getting lucky. If they do get through to the quarter-finals, you may even be able to sell the ticket on to somebody else for £100 or even more. But if we don't get through, then nobody you know's likely to buy the ticket from you, and you're anything up to £75 out of pocket.
Remember, however, that I've taken a gamble as well, because I may have forgone £25 by selling the ticket to you for £75 now when I may get £100 later on.
I have, in effect, sold you the right to attend a £100 event for £75, if everything works out well in the near future and England does get to play in the quarter-final. And you for your part have insured yourself against the risk of not getting a ticket to the match, by agreeing to pay me 75 per cent of the full £100 asking price. We've arranged a futures contract, in which we've both taken a risk but we're both a bit safer.
So far, so good. But actually futures contracts involve a bit more than I've suggested so far. In a real-world situation, you might say to me: 'Look, I'm not getting paid until the end of the month and besides, I don't see why I should pay you now for a match that I'm not attending until next month.'
'Fine,' I say, 'pay me 10 per cent of the £75 now (£7.50) and we can settle up the remaining £67.50 on the day of the match. Of course, if you manage to sell the ticket on to somebody else by that date, you're quids in. But remember, you still owe me the £67.50 even if you don't attend the match and you can't find anybody willing to buy the ticket. Can we shake hands on that?'
In the market's own lingo, I'm allowing you to trade on margin. I only do that because I trust you, and I'm probably not doing it at all unless I've already got your credit card details in case you mysteriously flee the country.
But you don't mind. 'That's great,' you think. 'I'm on to a good thing here, because I've got a ticket worth £100 that's going to be delivered to me on the day of the match, and I've only put down £7.50 up front. Now, I wonder what happens if I buy another nine tickets with the £67.50 that's still sitting here in my pocket? I'm buying £1,000 worth of tickets for only a £75 down-payment! (Or £750 by the time I finally settle up with the ticket tout.) Why, I can clear an easy £250 profit on this deal if England goes through and I can sell them all to my mates for £100 apiece. And all I've got to pay the ticket tout this afternoon is £75!'
At this point you might come unstuck. Putting down the £75 on margin is the easy bit. The tricky part will be explaining to your partner on the day of the match why you've now got ten useless tickets and owe me £750, because the national squad lost the qualifiers and nobody wants to buy them from you.
£750 is your total exposure on this contract, even though you only lay down £75. And you can be quite sure that I'll be sending the boys round to collect the missing £675!
This is an extreme scenario, of course, and in real life things don't often work out quite as badly as that. Even if your gamble doesn't come off, the chances are that you can still sell your tickets to some other country's supporter (or whatever) for £50 each, so that your losses on each ticket are only £17.50, plus the £7.50 you paid me on margin. But even then, you still lose £250 on the deal. Silly you.
I might also be able to sell the tickets on to somebody else, or get my supplier to take them back so that I can negotiate a mutually satisfactory exit from my futures deal with you, if that's what you request. (Who knows, maybe I never even had the tickets in the first place, but was just planning to get them from a mate if you agreed to go through with the deal and actually buy them from me?) One way or another, only a small proportion of futures contracts ever get to the stage of physical delivery (which in this case is when I hand you the tickets on the day of the match). Most contracts, in practice, are settled amicably or cancelled by mutual agreement before their expiry date comes up, so no goods ever actually change hands.
Another thing that wouldn't happen in real life is that I wouldn't simply take your credit card details. Instead, I'd ask you to set up an account with me, and to put enough money into the account to make sure that you'd covered at least a decent proportion of your exposure. Maybe I'd even let you have some interest on the account balance if I was feeling particularly kindly disposed toward you. But if I ever started getting anxious about the risks you were running – for instance, if our squad's star striker broke his leg and couldn't play – I'd be on the phone to you making a margin call. Which is to say, I'd insist that you put some more money into that account quick-sharp, or the deal's off.
Okay, our analogy with the football tickets has got us this far. And it's not so very far from reality, in fact, because people really do run futures on the price of tickets for the Wimbledon tennis tournament. But in the real world of business you don't deal in football tickets. Instead, you take calculated bets on other unknowables, such as the direction the stock market's likely to take, or the direction of the dollar. At this point I return to the question of leverage, or 'trading on margin' as it's also called.
The thing is, you can use a futures contract in two very different ways. You can either use it as a 'hedge', to reduce your risk, the way the Midwest grain merchants used to. Or else you can exploit the 'margin trading' principle, and the leverage it gives you, to take aggressively large speculative positions on the way you think things are going to go.
In the example of the football ticket, you decided to go for the aggressive approach and you acquired a £750 exposure by using your leverage on what was effectively a £75 bet (that is, a £75 margin payment). If your gamble works out and you get your ten £100 tickets for a final amount of £750, then you make an easy £250, a 333 per cent return on your margin stake! But if it fails, you've made a dreadful mistake. Your unsaleable tickets have left you £750 out of pocket. Ouch!
A wiser technique would have been to buy just the one ticket, lay down the £7.50 margin payment, and put the rest of the money in the bank where it would earn a bit of interest. But you wouldn't listen, would you? You might also have found some other way to balance your futures contract – for instance, by taking out a different bet against the chances of a Germany versus Italy clash in the same quarter finals, that would have paid out if you'd lost on your main contract. But instead of balancing your contracts sensibly against each other, you had to go and spoil it by 'going naked', as it's known. You didn't cover yourself against disaster!.
Warning
A futures contract is like a box of matches. Used sensibly, it can warm your home and keep you secure. Used recklessly, however, it can burn the whole place down.
What about hedge funds? Well, you've probably heard a lot of bad things about hedge funds in the last few years. They've been accused of creating the credit crunch of 2007 and 2008, by taking big risks on commodity prices and by playing all sorts of risky games with the shares of companies that are only important to them as pawns in a very complicated game. And then by selling them all off again, creating panic and disorder in the financial markets because nobody could really see what they were doing until it was too late and the crash had already started happening. They are, as the market says, 'lacking in transparency'. And that's putting it mildly.
I say in Chapter 14 on managed funds that these exotic funds have the freedom to invest in absolutely anything they like – stocks, bonds, cash, commodities – and that nobody can call them to account because they don't leave clear audit trails behind them. But hedge funds have been getting the blame for quite a lot of the volatility in commodities prices recently.
'Hedge? What hedge?' I hear you ask. 'No proper hedging's going on here, just out-and-out naked speculation, which is sending the markets into a real spin because nobody really knows how many of these contracts are just being drawn up for the sake of pushing prices up and down, instead of seeking safety and security.'
To that I can only say amen. If the 2007/2008 stock market panic didn't convince you that speculative futures activity from hedge funds is a dangerous thing, then I don't know what will. But then, stable markets aren't much use to a hedge fund manager. He makes her money by exploiting the twists and turns of the market, and she thrives on volatility. If everybody's settled into the status quo, then no trading's going on. And if no trading's happening, then no opportunities exist to turn a profit on a deal.
The nearby sidebar concerns the grain farming trade, where futures started out. But in time, the American futures trading business spread to include other types of commodities: oil, copper, gold, and all sorts of highly price-volatile things. When you look at the oil or metals prices listed in the papers, the chances are that they say something like 'tin for November 2011 delivery' (or some date in the future). That is, somebody's offering a futures contract that effectively sets out what the expected tin price is in the future, and asks you to take a gamble on whether the guess is right or not.
Except that the gamble isn't quite as big as it may appear. By fixing the future price at which you're going to buy that tin, you're protecting yourself and using the futures contract as a tool to stabilise your business.
Airlines and bus companies use futures contracts to protect themselves against sharp fluctuations in fuel costs. Doing so helps them keep their books on an even keel while prices are swooping about, and that in turn helps their investors stop worrying about the volatility of the companies' cost bases.
Things get even more interesting in the mining industry. Gold producers, who have seen the value of their output shooting up and down in recent years, are increasingly using the futures business to bet against falls in the gold price! Yes, they can and they do. If a company suspects that the price may go down, it might take out contracts that will produce disproportionately large returns if its worst fears are realised. These returns will then help to repair the damage to its bottom line. The company's said to be fully hedged (or '80 per cent hedged', or whatever.)
Open a typical paper and you'll search in vain for the details of all the thousands of futures contracts that are set up and traded every day. And no wonder. There are simply too many of them to be worth listing, even if anybody were interested in reading them. Instead, you're more likely to learn something from the lists of indices that commodity exchanges like the Chicago Board of Trade or the New York Nymex posts up. These will give you the flavour of the trades that are happening right now, but not the details, which are crashingly boring. You can find some links to these price lists, and some illustrations of what they look like, in Chapter 13.
Tip
As a general principle, the further ahead a futures contract is set to expire, the greater the uncertainty about the underlying prices that are being bet on. So a one-month futures contract is probably rather closer to the current price than a six-month contract, where much more guesswork's involved.
Warrants are rather safer than the futures contracts the preceding section describes. With a futures contract, you can lose more than your original stake if your bets come seriously unstuck. But with a warrant you can just walk away, take your losses, and chuck your betting slip in the bin.
A warrant is a special kind of security that a company issues in order to raise money. It isn't a share as such, but you can convert it into a share if that's what you decide to do. Your decision's likely to depend on how high the share price has gone.
With a warrant, the deal is that you pay a fairly modest amount of money for a piece of paper that entitles you, for example, to buy a fixed number of company ABC's shares at a price of 200p each, by a certain date (the expiration date). This is called exercising the warrant. And if the share price doesn't reach that level by the expiration date, you simply walk away and write off your loss.
That may not sound like a very attractive prospect if the 'target' share price is only 100p at the moment; but as ABC's share price rises, so does the value of the warrant – disproportionately so, in fact, and not surprisingly too. If the going rate for the share is, say, 25 per cent of the warrant price, then the chances of the warrant ever being worth anything can be considered minimal; but by the time it reaches 80 per cent of the warrant price, the odds are more heavily stacked in your favour.
Why would any company want to issue a warrant in the first place? Usually, it issues a warrant as an attachment to a corporate bond or a preference share (see Chapters 6 and 9 on these), as compensation for the fact that the bond or preference share carries a fairly low rate of interest (or dividend). However, because the warrant can then be 'stripped' from the share and sold to somebody else, it then becomes a marketable security in its own right.
Next question. When you exercise your warrants and convert them into shares, where do those shares come from? Does the company fish them out of a sack that it keeps topped up for the purpose and hand them to you? Sadly, no. When you exercise a warrant, the company issues brand new shares to run alongside the existing shares. And since the company hasn't grown in size to match the emergence of the new shares, warrants are therefore dilutive of the company's equity. So they're not popular with the other shareholders whose own shares are being diluted. All companies are required to officially declare it when warrants are redeemed, by issuing a Regulatory News Service statement, just so that everybody knows what's going on. (I discuss RNS statements in Chapter 8)
Quite a few different types of warrant exist:
Call warrants: which allow you to buy the underlying shares.
Put warrants: which let you sell the underlying shares.
Covered warrants: which means the company's put up some independent financial backing for the warrants, so that they don't dilute the equity. Often it achieves this by using cash, not equity, to cover the value of the warrant.
Basket warrants: which track an entire group of shares, or indeed an entire industry sector rather than just one company's shares.
Where do you find warrants? Not on the main stock market, as a rule, although exceptions apply. You're more likely to track them down on the over-the-counter market (OTC), which is more lightly regulated than the main stock market. You won't find much information on the OTC market in the papers or on the Web, but a good stockbroker should be able to help you research and trade this market. It's not the safest of activities for a raw beginner, though, because of the lack of regulation, so be very careful.
Options are another kind of derivative that you'll often read about in the financial pages, so it's important to have a working understanding of what they are even if you're never actually going to need to trade them. I want to say straight away that options are slightly less dangerous beasts than futures, for the very good reason that you don't run the risk of losing more than your original stake if things go wrong. But at the same time they're more likely to come your way than warrants (see the preceding section).
Why? Because options are often handed out to a company's staff, as part of a pay package. Especially if you're a director or a senior employee. They're a bit similar to the employee share schemes that your employer may make available to you, but without the tax advantages, because your gains are taxable under all circumstances if you make a profit when you exercise them. Moreover, unlike conventional options, employee share schemes don't generally have an expiration date by which they must be exercised.
What are options? Well, let's start out with the formal definition, the same way that we did when we considered futures, and then we'll take it from there. An option is a piece of paper that gives its holder the right to buy (or sell) a share, or a bond, or any other security, at a fixed price (which is usually called the 'strike price'), at any time up to a particular date in the future. As with warrants, the holder of the option isn't obliged to go throught with the deal - instead, he or she can simply walk away if the price doesn't look attractive when the expiry date (or 'maturity date') approaches. So there's a definite floor to how badly off you can end up.
Options come in two flavours. A call option entitles you to buy the underlying shares, bonds or whatever, at the agreed price, and a put option entitles you to sell it, also at the agreed price. But you'll also find that options are available for entire stock market indices, or for currencies (you can get a call option on the dollar, for instance).
Assuming that we're talking about a share, you can exercise the option at any time up to the expiration date. (Unless it's something called a 'European option', in which case you can only exercise it on the expiration date, and at no other time.) You can also sell your options to a third party.
As with a warrant, the company will need to issue some new shares with which to redeem your options when you exercise them – and this doesn't go down at all well with shareholders, who once again see their equity being diluted by the new issues.
Beyond this brief overview, I'm afraid the subject is veiled in complexity. A whole convoluted vocabulary is associated with options investing, and I don't propose to take you into it. Strangles, straddles, butterfly spreads, and iron condors are just the start of it. When you're ready for that sort of heavy talk, you won't need this book any more. And good luck to you.