Derivatives trading explained

Johannesburg - Derivatives is a buzzword that is often misused or misunderstood.

If you ask ten different asset managers or investors what a derivative is, you are more than likely going to receive just as many answers.

“Derivatives are financial instruments that derive their value from the values of an underlying variable: The ultimate payoff to the investor depends directly on the value of a variable,” explains Mabyanine Phiri, portfolio associate at ACM Gold.

“The financial market is a network where buyers and sellers trade financial instruments like shares of companies and derivatives."

The price of a company share is consolidated from the value, profitability and performance, amongst other factors, of that particular company that issued that share.

The price of a share derivative or exchange traded derivative, for example, is “derived” directly from that company share price,” explains Phiri.

Derivatives facilitate the management of financial risk exposure as they allow investors to transfer financial risk.

"In principle, derivatives markets could contribute to efficient asset allocation, create more opportunities for diversification of portfolios, price discovery, and more public information,” said Phiri.

“Derivatives can be privately negotiated over-the-counter or traded on organised exchanges such as the JSE, London International Financial Futures and Options Exchange (Liffe) and the Chicago Board of Trade."

The JSE trades derivative products mostly on the equity derivatives market, currency derivative market, commodity derivate market and on the interest rate market.

Futures contracts, forward contracts, options and swaps are some of the most common types of derivatives.

Participants in the derivatives market

“Participants in the derivatives market are hedgers, speculators or arbitrageurs who use derivatives markets for income enhancement," said Phiri.

Hedgers are entities (investors, lenders, borrowers, producers, manufacturers) that are exposed to the risk of adverse cash-market price movements.

Speculators attempt to make profits by taking a view on the market and if their views are right they make money and if wrong they lose money.

Speculators are willing to bear risk that others such as hedgers aim to avoid.

“For example, a European investor purchasing shares of an American company off an American exchange (using US dollars) would be exposed to exchange-rate risk while holding that stock," said Phiri.

To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros.

“It is important to note that trading derivatives comprises of major risks. One of the main risks is the possibility of losing more money than you started with," said Phiri.

"The risk of loss in trading futures contracts or commodity options can also be substantial and investors need to understand the risks involved in taking leveraged positions.”

Phiri said 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," he said.

"Although derivatives trading can be rewarding, it is important to carefully consider whether such trading is suitable for you in light of your circumstances and financial resources."

- Fin24

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