Use Derivatives

Let’s start at the beginning, by addressing the fundamental question…‘what is a derivative?‘

Derivatives are financial instruments that derive their value from an underlying instrument (such as shares, share price indices, fixed interest securities, commodities, currencies etc). Some examples of derivatives are warrants, futures and exchange- traded options.

The purpose of derivatives is to provide a means of accessing and trading in the value of the underlying financial instrument (on which the derivative is based), without having to put up the capital for the full value of that underlying instrument.

Derivatives are usually only offered on the top 20 to 50 stocks in the equity market, and there are often liquidity (and other) constraints.

‘Derivatives’ is a term that often confuses and as such, many people perceive them to be extremely risky. But then investing in anything is risky for some people because they do not understand the markets, or because they are sometimes foolish, or because they are totally risk averse.

As we have said many times before, life and investing per se are always risky, and risks vary from the minimal to the ridiculous.

Let’s stick to the facts.
Derivative instruments are usually riskier in nature than investing in the underlying instruments themselves, but the quid pro quo is that the returns on money invested may be higher. You do need to know what you are doing in the derivatives market. However, with a clear and defined strategy, derivative trading can be an integral part of a successful portfolio.

Why use Derivatives?
Often perceived as advanced instruments traded only by professionals, derivatives are also traded by retail investors. Equity derivatives such as warrants and options, offer the opportunity to earn extra income from shares, or to protect the value of existing shareholdings. Investors can also use derivative products to hedge their portfolios, gain broader exposure to the market, or even speculate by using the leverage opportunities that some derivatives offer.

As the basic maxim of investing states, the higher the risk, the higher the return - and vice versa.

Derivatives can also be used as a risk management tool in so far as they can expose you to more or less risk depending on how you use them. Options and warrants can be used to help increase your exposure to a particular security, such as a share, or they can help you protect your position from a price fall.

Some key reasons for using derivatives include…

Leverage
Derivatives give an investor the ability to access the movement in the share price for a low investment. It is similar to putting down a deposit on a house; the derivatives market allows you to put down a deposit on a share and access the benefits of the movement in the share price.

Hedging
Hedging allows investors to protect the value of shares they own - effectively like taking out insurance in the share market. As the share price drops in value this particular derivative increases in value.

Income
Investors can generate an income from shares they own - this is in effect like renting out a property. But it is also possible to ‘rent out’ the shares you own using options to generate an income. Warrants cannot be used to do this.

Long or Short
Derivatives can be used to profit even when shares are dropping in value. No longer do you have to sit and wait for the share to turn around and start to climb before you are making money. You can be making money regardless of which direction the share moves in. Using derivatives you could make as much money on the way up as on the way down.

Once again, knowledge is the key!

One of the biggest mistakes people make when using derivatives is not knowing which derivative product to choose. For example, purchasing an ‘out of the money’ call option in the hope of capturing a rise in the share price, only to be left confused when the stock price reaches the target, but the option price has in fact lost money! That is why we only put forward derivative strategies that also identify which product to buy - one of the most important aspects of trading. We use a risk-to-reward ratio to help choose the best product.