THIS month I am continuing on
my journey of enlightenment
through the often confusing world
of investment options and
opportunities in an attempt to demystify
some of the jargon
and concepts with
which you may
already have a degree
of passing
acquaintance but
which, in reality, all
still sounds far too
tricky and confusing.
This month’s
subject matter is
“financial derivatives”
but what is a derivative?
Derivatives are so
called because their
value is derived from
an underlying
investment. These include shares,
indices, bonds and currencies as well
as commodities such as oil and metals.
An investor can gain exposure to
an underlying investment without
having to own it directly. This can
reduce expenses and ease
administration. A derivative based on
the FTSE 100 index would allow
investment in the FTSE 100 without
having to buy each constituent share.
Derivatives can add risk but also
reduce it. Many fund managers now
use them as a matter of course to gain
exposure to investments in a cost
effective and easily administered way.
Advantages
The use of derivatives, rather than
buying the underlying asset directly,
offers a number of advantages:
- transaction costs are lower;
- derivative contracts are often more
liquid than the market for the
underlying asset; - transactions can be executed more
rapidly; - short positions (benefiting from
falling prices of assets you don’t own) can be achieved.
Typically there are two kinds of
derivatives traded in markets: futures
and options.
Disadvantages
- Derivatives are
complicated and
even many fund
managers may not
understand them
sufficiently to be
using them wisely.
They should only be
used if individuals
have a full
understanding of
them, otherwise they
should seek expert
advice. - Some derivatives are relatively low risk,
such as US Treasury futures, but others carry greater
potential for volatility. - An investor should know whether a
fund they have a position in is
investing in derivatives. It may not be a
bad thing, but it does increase risk
within a portfolio so it is important
that you make sure this still fits their
objectives.
What is a future?
A future is a contract to buy or sell an
asset at a future specified date for a
specific price.
Each futures contract will specify
the amount of the asset to be
exchanged. Futures contracts are non-
negotiable, i.e. they are an obligation.
The buyer of a futures contract is
taking a “long” position and is seeking
to make a gain if the value of the asset
rises above the specified maturity price.
The seller of a futures contract is
said to have taken a “short” position as
he or she will make a gain if the value
of the asset falls or doesn’t reach the
specified price and will have a
guaranteed selling price above the
market value.
What are the margining system
and clearing house?
In order to ensure the credibility and
liquidity of the futures market an
independent body is required to oversee
and facilitate transactions. The clearing
house satisfies this requirement by
guaranteeing the fulfilment of each
contract.
The clearing house requires each
trader to make a deposit, known as the
initial margin, to cover the maximum
likely daily loss from each futures
contract.
At the end of each trading day the
clearing house will collect payment
from those traders who have made a
loss and pay those who have made a profit. This
daily amount is known as
the variation margin.
In the event of a
trader not being able to
pay this margin, the
clearing house has the
deposit or initial margin
to fall back on and does
not lose out.
Most contracts are
settled by cash payment.
This is known as “closing
out”. In a large number
of cases the positions are
closed out before
maturity. Leveraging is
possible since traders only
need to find the initial
and variation margins, not
the full cost of the contract.
What is an option?
An option contract gives the holder the
right to buy or sell an asset at a
specified price (the exercise or strike
price) by, or on, a specified date.
However, as the name suggests, the
holder is not obligated to buy or sell the
asset and may let the option lapse.
Options may be European style, which
can only be exercised on a specific
maturity date, or American style, which
may be exercised any time before or on
the maturity date.
When buying an option the price paid is known as the premium. This
represents the maximum profit for the
writer (seller of the option) and the
maximum loss the buyer will experience
if the option is not exercised.
“Put” and “call” options
A “call” option gives the holder the
right to buy an asset from the option
writer. A “put” option gives the right to
sell an asset to the option writer.
A holder of a call option expects
the value of the asset on which the
option is based to rise above the
exercise price plus premium. When it
achieves this it is said to be “in the
money”. The higher the value rises above this, the greater
the profit made.
The holder is able to
buy the assets from the
writer and sell them in
the market to make the
profit. If the underlying
value does not rise
above this, the option is
“out of the money” and
the option holder will let
the option lapse and will
only have suffered the
premium.
Conversely, the
buyer of a put option is
expecting the value of
the underlying asset to
fall below the exercise
price minus the
premium. The further the value falls below this, the greater the
profit. If the value does not fall
sufficiently, the holder will not exercise
the put option and only lose the
premium.
- For further information or to discuss
any aspect of financial planning,
contact the author, a founder member
of The Ellis McComb Partnership, 3
Mortimer Street, Birkenhead, Wirral
CH41 5EU; telephone 0151 650 6520,
e-mail ellis.mccomb@sjpp.co.uk;
website www.ellismccomb.co.uk. The
Ellis McComb Partnership is an
appointed representative of St James’s
Place Wealth Management plc.
