When people talk of derivatives they are usually not referring to the range of collective investments but mean highly-geared gambles requiring extensive knowledge, continuous attention and deep pockets. Even the professionals got it so spectacularly wrong that the derivatives mire rocked the foundations of the global economy in the 1990s and swallowed some of the world’s largest finance houses, banks and insurance companies between 2007 and 2009. If the ‘expert’ financiers who are paid millions a year can get it so hugely wrong that they bankrupted multibillion pound companies, a small amateur is unlikely to survive long. These shark-infested waters are too dangerous for small or inexperienced investors.
This section therefore is intended as background rather than temptation. Some readers of this book may be gamblers, rich enough to bet on long odds, or grow experienced enough to venture into such treacherous areas. That is the speculative end of derivatives. For others it may also act as a safety net by hedging a perceived risk, or by fixing the price at which to trade within a specific time. But even then one needs a feel for the market.
There is a huge selection of ever more complicated derivatives. They include futures, options and swaps with a growing collection of increasingly exotic and complex instruments. These derivatives are contracts derived from or relying on some other thing of value, an underlying asset or indicator, such as commodities, equities, residential mortgages, commercial property, loans, bonds or other forms of credit, interest rates, energy prices, exchange rates, stock market indices, rates of inflation, weather conditions, or yet more derivatives.
They are nothing new. Thales of Miletus in the 6th century bc was mocked for being a philosopher, an occupation that would keep him poor. To prove them wrong he used his little cash to reserve early all the oil presses for his exclusive use at harvest time. He got them cheap because nobody knew how much demand there would be when the harvest came around. According to Aristotle, ‘When the harvest-time came, and many were suddenly wanted all at once, he let them out at any rate which he pleased, and made a quantity of money’, showing thinkers could be rich if they tried but their interest lay elsewhere (Politics Bk1 Ch11). There is some dispute as to whether this was an options or forward contract but either way it shows derivatives have a long history.
Derivatives are generally analogous to an insurance contract since the principal function is offsetting some impending risk (‘hedging’, as the financial world calls it) by one side of the contract, and taking on the risk for a fee on the other. In addition there is the straight gamble of taking a punt on the value of something moving in one direction.
Hedging can entail using a futures contract to sell an asset at a specified price on a stated date (such as a commodity, a parcel of bonds or shares, and so on). The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract. This allows the individual or institution the benefit of holding the asset while reducing the risk that the future selling price will deviate unexpectedly from the market’s current assessment of the future value of the asset.
Derivatives allow investors to earn large returns from small movements in the underlying asset’s price, but, as is usual, by the same token they could lose large amounts if the price moves against them significantly, as was shown by the 2009 need to recapitalize the giant American International Group with $85 billion of debt provided by the US federal government. It had lost more than $18 billion over the preceding three quarters on credit default swaps (CDSs) with more losses in prospect. Orange County in California was bankrupted in 1994 through losing about $1.6 billion in derivatives trading. But the sky really fell in from 2007 onwards when it became clear that most of the major banks had traded in complex derivatives without the slightest understanding of the origin, risk and implications of what they were doing.
There are three main types of derivatives: swaps, futures/forwards, and options, though they can also be combined. For example, the holder of a ‘swaption’ has the right, but not the obligation, to enter into a swap on or before a specified future date.
Futures/forwards are contracts to buy or sell an asset on or before a date at a price specified today. A futures agreement is a standardized contract written by a clearing house and exchange where the contract can be bought and sold; a forward is negotiated for a specific arrangement by the two sides to the deal.
The facility, as with so many derivatives, was originally created as a way of ‘hedging’ or offloading risk. For instance, a business exporting to the United States can shield itself against currency fluctuations by buying ‘forward’ currency. That provides the right to have dollars at a specific date at a known exchange rate so it can predict the revenue from its overseas contract. If some shares had to be sold at some known date (say to satisfy a debt) and the investor was nervous that the market might fall in the meantime, it is possible to agree a selling price now.
A gambler decides to buy a futures contract of £1,000 (it almost does not matter what lies behind the derivative – it could be grain, shares, currencies, gilts or chromium). It costs only 10 per cent (called the ‘margin’ in the trade), so in this case £100. That shows the business is geared up enormously. Three months later the price is up to £1,500 so the lucky person can sell at a £500 profit, which is five times the original stake. It could also happen though that the price drops to £500 and he or she decides to get out before it gets worse. On the same reckoning the loss of £500 is also five times the original money. This shows that, unlike investment in shares or warrants, where the maximum loss is the amount of the purchase money, the possible downside of a futures deal is many times the original investment.
Futures contracts can be sold before the maturity date and the price will depend on the price of the underlying security. If you fail to act in time and sell a contract, the contract can now be rolled over into the next period or the intermediary arranging the contract will close and remit profits or deduct losses.
There is also an ‘index future’, which is an outright bet similar to backing a horse, with the money being won or lost depending on the level of the index at the time the bet matures. A FTSE100 Index future values a one-point difference between the bet and the Index at £25.
An extension of that is ‘spread trading’, which is just out and out gambling on some event or trend vaguely connected to the stock market or some financially related event. It could be anything from the level of the FTSE100 Index to the survival of a major company’s chief executive in his or her troubled job. If the spread betting company is quoting 4,460 to 4,800 or if the market-makers are quoting 40 to 42 days for the chief executive and somebody thought it would be less than a month, it is possible to ‘sell’ at 40; while somebody reckoning the chances are better than that and the executive could be there for months to come would ‘buy’ at 42. Then if the person lasted 47 days before getting the elbow, the buyers would have won by five days and their winnings would depend on how much they staked – at £1,000 a day they would have cleared £5,000. The sellers, however, would have lost by seven days and once again their debt would depend on how much they staked. The market- maker makes a profit on the spread between the two (if running an even book), just as do market-makers in ordinary shares.
The spread betting company, say, offers Brigantine & Fossbender at 361 to 371p. If you think the shares will rise substantially you buy at 371 in units of £10. If you are right and the price then goes to 390p, the shares have appreciated by 19p above your betting price (assuming one unit) and the proceeds are therefore £190. That sounds good until you consider that if the shares had instead dropped to 340p, your losses would be £210. Conversely, if you think the shares will fall, you ‘sell’ at 361p and the same mathematics applies the other way. If the price remains within the 361 to 371p range nobody wins.
2. Contract for difference
This is a contract that mirrors precisely dealing in an asset, without any of it actually changing hands. If the price has risen by the end of the stated period the seller pays the buyer the difference in price, and if the price has fallen the buyer pays the seller the difference. CFDs are available in unlisted or listed markets in the United Kingdom, the Netherlands, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, France, Ireland, Japan and Spain, but not the United States where they are banned, but they do have margin trading. The asset can be shares, index, commodity, currency, gold, bonds, etc.
The trades do not confer ownership of the underlying asset but involve taking a punt on the price movement, so the contracts offer all the benefits of trading shares without having to own them. Being risky, the contracts are available only to non-private, intermediate customers as defined by the Financial Conduct Authority.
Investors in CFDs are required to maintain a margin as defined by the brokerage or market-maker, usually from 1 to 30 per cent of the notional value of leading equities. That means investors need only a small proportion of the value of a position to trade and hence they offer exposure to the markets at a small percentage of the cost of owning the actual share. It offers opportunities for large gearing up – 1:100 when trading an index. It allows taking long or short positions, and unlike futures contracts a contract for difference has no fixed expiry date, standardized contract or contract size. As in the underlying market, taking a long position produces a profit if the contract value increases, and a short position benefits if the value falls.
There is a daily financing charge for the long side of the contracts, at an agreed rate linked to LIBOR (see Glossary) or other interest rate, so a delay in closing can be expensive. Traditionally, CFDs are subject to a commission charge on equities that is a percentage of the size of the position for each trade. Alternatively, an investor can opt to trade with a market-maker, foregoing commissions at the expense of a larger bid/offer spread on the instrument. The contracts can hedge against short-term corrective moves, but do not incur the costs and taxes associated with the premature sale of an equity position. As no equities change hands, the contracts are exempt from stamp duty.
Like all highly geared deals, exposure is not limited to the initial investment. The risk can be mitigated through ‘stop orders’ (guaranteed stop-loss orders cost an additional one-point premium on the position and/or an inflated commission on the trade). A stop-loss can be set to trigger an exit, eg buy at 300p with a stop-loss at 260p. Once the stoploss is triggered, the CFD provider sells.
The device is convenient if used under around 10 weeks – the point where financing exceeds the financing charge for stocks – while futures are preferred by professionals for indexes and interest rates trading. It is also fairly well hidden – a group of hedge funds linked to BAE Systems acquired more than 15 per cent of Alvis through CFDs without having to warn the regulator.
Acquiring 1,000 Bloggins & Snooks plc shares at 350p each would need £3,500. Using contracts for difference, trading on a 5 per cent margin, you would need only an initial deposit of £175. If you had £175 to invest, and wanted to buy Bloggins & Snooks plc at 350p and sell at 370p, a standard trade would be:
buy: 50 x 350p = £175
sell: 50 x 370p = £185
profit = £10 or 5.7 per cent.
buy: 1,000 x 350p =
£175 (5 per cent deposit) + £3,325 (95 per cent borrowed funds)
sell: 1,000 x 370p = £3,700
profit = £200 or 114 per cent.
Although the profit after gearing was far greater, losses are comparably magnified.
Options give the right, but not the obligation, to buy (in the case of a ‘call option’) or sell (in the case of a ‘put option’) an asset. That is how they differ from futures, which have an obligation to trade. The price at which the trade takes place, known as the ‘strike price’, is specified at the start. In European options, the owner has the right to require the sale to take place on (but not before) the maturity date; in US options, the owner can require the sale to take place at any time up to the maturity date.
If, during the time a put option is in force the share price falls significantly, the investor can make a handsome profit by buying the cheaper shares in the market and exercising the option by selling them at the agreed price. Similarly, in reverse, a call option is handy if you think they will rise substantially in the interim. Come the contracted day, however, and the price has moved the wrong way, one can just walk away and opt not to exercise the option. All that has been lost is the margin of option money, which is a lot less painful than if the underlying security had been bought and sold.
This is another way of hedging one’s position. Say somebody knows that for some reason they will have to sell a parcel of shares in eight months’ time – to fund the down-payment on a house, for instance. But there is a worry the market may slump in the meantime: buying a put option at roughly today’s price provides a way of buying protection. If it is one of the 70 or so companies with options traded in the market, there is also the chance to sell the option before expiry since, like most derivatives, options can be traded before maturity.
A company languishing in a troubled sector may look to an astute observer to be about to turn itself round, become a recovery stock, and astonish everyone. But if the observer is also astute enough to have misgivings about such uniquely prescient insight, and worries about committing too much money to the hunch, there is a cheap way in. One simply buys an option to buy.
So if Bathplug & Harbottle shares are standing at 75p, it can cost, say, 6p to establish the right to buy shares at that price at any time over the next three months. If in that time the shares do in fact fulfil the forecast and jump to 120p, the astute investor can buy and immediately sell them at a profit of 39p a share. If the misgivings prove justified and the shares fail to respond or even slump further, only 6p instead of 75p has been lost.
The whole thing works the other way as well, so the suspicion but not total certainty that a company is about to be seriously hammered by the market could prompt someone to buy a put option. That is the right to sell the shares at a specified price, within an agreed set of dates.
These rights have a value as well, related to how the underlying share is performing and how long they have to run, so they can be traded, mostly on the London International Financial Futures and Options Exchange (generally abbreviated to Liffe, pronounced ‘life’ rather than like the river flowing through Dublin). The traded options market deals in parcels of options for 1,000 shares and at several expiry dates, with some above and some below the prevailing market price for about 70 of the largest companies.
When one buys a security or direct investment, for example 100 shares of South Seas at £5 each, the capital result is linear. So if the price appreciates to £7.50, we have made £250, but if the price depreciates to £2.50 we have lost £250. Buying a one-month call option on South Seas with a strike price of £5 would give the right but not the obligation to buy South Seas at £5 in one month’s time. Instead of immediately paying £500 and receiving the stock, it might cost £70 today for this right. If South Seas goes to £7.50 in one month’s time, exercising the option by buying the shares at the strike price and selling them would produce a net profit of £180. If the share price had gone to £2.50, the loss would have been restricted to the £70 premium. If during the period of the option the shares soar to £10 the option can be sold for £430. An option provides flexibility.
In normal usage a ‘warrant’ is a sort of guarantee, but in the stock market it is a piece of paper entitling one to buy a specified company’s shares at a fixed price. These are equivalents of share options – though generally with the longer life of between three and 10 years – and can therefore be traded. In effect it is a call option issued by a company on its own stock. The company specifies the exercise price and maturity date. The price will be set by a combination of the conversion price and the prevailing price of the actual shares already being traded.
A ‘covered warrant’ is different, and the ‘covered’ bit has long been abandoned. It conveys the right to buy or sell an asset (generally a share) at a fixed price (called the ‘exercise price’) up to a specified date (called the ‘expiry date’). It can also be based on a wide variety of other financial assets such as an index like the FTSE100, a basket of shares, a commodity such as gold, silver, currency or oil, or even the UK housing market. As with other derivatives, investors can use it to gear up their speculation or use it as a way of hedging against a market fall or even for tax planning. Unlike ‘corporate warrants’, which are issued by a company to raise money, a covered warrant is issued by a bank or other financial institution as a pure trading instrument. Covered warrants can either be US warrants (exercised any time before expiry) or European (exercised only on the date specified) but most are simply bought and then sold back to the issuer before expiry. If a warrant is held to expiry, it is bought back for cash automatically, with the issuer paying the difference between the exercise price and the price of the underlying security.
There are a number of issuers offering over 500 warrants and certificates on single shares and indices in the United Kingdom and around the world. They tend to be major global investment banks that have ‘bid’ (buy) and ‘offer’ (sell) prices for their warrants during normal market hours in exactly the same way as shares. Investors trade in them through a stockbroker, bank or financial adviser, just as with ordinary shares. Launched in 2002 there are now more than 70 brokers trading. Germany launched its covered warrants market three years earlier in 1989.
A covered warrant costs less than the underlying security; this provides an element of ‘gearing’ so when the price of the underlying asset moves, the warrant’s price moves proportionately further. It is therefore riskier than buying the underlying asset. A relatively small outlay can produce a large economic exposure, which makes warrants volatile, and that means they can produce a large return or lose the complete cost of the warrant price (confusingly called the ‘premium’) if the underlying security falls below the purchase price (it is ‘out of the money’). In addition, warrants have limited lives and their value tends to erode as the expiry date approaches.
Covered warrants can be used to make both upwards and downwards bets on an underlying asset. Buying a ‘call’ is a bet on an upward movement. Buying a ‘put’ is a bet on a downward movement. With both kinds of bet the most an investor can lose is the cost of the warrant. Covered warrants are like options but are freely traded and listed on a stock exchange – they are securitized. As a result, they are easy for ordinary private investors to buy and sell through their usual stockbroker.
Swaps are contracts to exchange cash flows on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/ interest rates, commodities, stocks or other assets. Interest-rate swaps account for the majority of banks’ swap activity, with the fixed-for- floating-rate being most common. In that deal one side agrees to make fixed-rate interest payments in return for floating-rate interest payments from the other, with the interest-rate payment calculations based on a hypothetical amount of principal called the ‘notional amount’. Swaps, forward rate agreements and exotic options are almost always agreed privately, unlike exchange-traded derivatives.
As revered investor Warren Buffett warned in his Berkshire Hathaway 2002 annual report, ‘We view them as time bombs both for the parties that deal in them and the economic system … In our view … derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.’
The original purpose of inventing most of them was to reduce somebody’s risk – a sort of hedging device. It works in commodities, for instance when a farmer tries to find protection from the potential hazard of a huge harvest (of wheat, oranges, coffee and so on) with the consequent plummeting prices, by agreeing a price earlier and before the size of the harvest is known. If the crop turns out to have been meagre a huge profit may have been forfeited from a big price hike, but the farmer was protected from penury if it had gone the other way.
Source: Becket Michael (2014), How the Stock Market Works: A Beginner’s Guide to Investment, Kogan Page; Fifth edition.
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