Trading in derivatives has always been known to be incredibly hard for most people but quite simple for some. The truth is, however, that while some types of derivatives have turned increasingly unreliable and maybe even too complex to trade, some are still going strong as great investment options.
Despite it maybe being more difficult to grasp than other financial instruments, derivatives are one that is highly recommended studying. Derivatives have become so entwined with the global economy that it is crucial for any finance professional to understand them.
Given the much-too-high number of derivative products available since the beginning, perhaps it’s easy to understand why some investors might find them confusing, if not intimidating.
Given the much-too-high number of derivative products available since the beginning, perhaps it’s easy to understand why some investors might find them confusing, if not intimidating. But the commonly used derivatives are based on simple logic. This will become clearer as we disentangle the concept by taking a step back, work our way up from basics and simplify the science behind trading in derivatives.
So, what are derivatives?
Derivatives are one of the three main categories of financial instruments, the other two being stocks (i.e. equities or shares) and debt (i.e. bonds and mortgages).
Derivatives, as the name suggest, are based on some underlying value. The same applies to the financial concept – it’s a product whose value derives from and is dependent on the value of an underlying asset, which can be commodities, precious metals, currency, bonds, stocks or stocks indices, among others.
Derivatives are contracts used by traders to speculate on the future price movements of an underlying asset, without having to purchase the actual asset itself, in the hope of booking a profit. So, essentially a buyer makes a contract with a trader to pay up, say for a 100 units of a stock at Dh15 (existing market price) for a tenure of 6 months. So, the buyer is hedging his bet.
Now if the price goes up, the trader has to bear the difference and the buyer gets a deal, which he/she can sell to make a profit, and if it drops then the buyer still pays the price he/she agreed upon. Traders or businesses also use derivatives for hedging purposes by mitigating risk against another (possible loss-making) position they have taken in the market.
Popular types
To better understand what derivatives are and to gradually delve deeper into how they work, let’s now look at some of the most widely used types of derivative products:
The most popular types of derivative products include ‘Forwards’, ‘Futures’, ‘Options’, ‘Swaps’, ‘Contract For Difference’ and ‘Credit Derivatives’. For each of the types of derivatives, there are numerous different sub-types, some of which we will explore further below.
Let’s first break these down and briefly see what each of them are about.
Forwards and Futures contracts – These are contracts that require the contracts’ buyers to purchase an asset at a pre-agreed price on a specified future date. Both forwards and futures are essentially the same in their nature.
However, forwards are more flexible contracts because the parties can customise the underlying commodity as well as the quantity of the commodity and the date of the transaction, whereas futures are standardised contracts with no flexibility in these aspects. The major difference between the two is that futures are traded publicly on exchanges and the forwards are privately traded.
Both forwards and futures are essentially the same in their nature. The major difference between the two is that futures are traded publicly on exchanges and the forwards are privately traded.
An example of futures contract is when oil prices went from less than $60 a barrel in 2007 to $140 a barrel a year later. A decade before the spike in prices, an airlines company SW had begun a practice of buying oil futures with a delivery date of about one year out and with a price that was just a little higher than the current price.
That means when oil was selling for $60 a barrel in 2007, SW was buying oil futures for the same month in 2008 for about $65. Then, a year later, when oil prices were $140, SW was making money on their $65 oil futures contracts.
Now an example for forwards contract. If you were a farmer and you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever the price is when you harvest it, or you could lock in a price now by selling a forward contract that obligates you to sell 500 bushels of wheat to, say, Kellogg after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices.
On the other hand, if prices rise later, you will get only what your contract entitles you to. (Although if you are Kellogg, you might want to purchase a forward contract to lock in prices and control your costs – but you might end up overpaying or (hopefully) underpaying for the wheat depending on the market price when you take delivery of the wheat.)
Options contracts – Like the name suggests an options contract gives the buyer (the owner or holder of the option) a choice to trade the underlying asset at a specified price on or before a specified date – or walk away if you want. The seller of these contracts is obligated to buy the asset if the buyer chooses to exercise their option to do so. There are two types of options: ‘call’ and ‘put’.
• ‘Call’ option contracts: These contracts give the buyer an option to buy the underlying asset at the price specified in the option contract. Investors buy the contracts when they believe the price of the underlying asset will increase and sell them if they believe it will decrease.
• ‘Put’ options: Puts give the buyer an option to sell the underlying asset at the price specified in the contract. Investors buy the contracts when they believe the price of the underlying asset will decrease and sell them if they believe it will increase.
For example, stock options (a sub-type of options) are options for 100 shares of the underlying stock. Assume a trader buys one ‘call’ option contract on ABC stock with a set price of $25 (Dh91.83). He pays $150 (Dh550.95) for the option. On the option’s expiration date, ABC stock shares are selling for $35 (Dh128.56). The buyer/holder of the option exercises his right to purchase 100 shares of ABC at $25 a share (the option’s set price).
He immediately sells the shares at the current market price of $35 per share. He paid $2,500 (Dh9,183) for the 100 shares ($25 x 100) and sells the shares for $3,500 ($35 x 100) (Dh12,856). His profit from the option is $1,000 ($3,500 – $2,500), minus the $150 premium paid for the option. Thus, his net profit, excluding transaction costs, is $850 ($1,000 – $150) (Dh3,122.05). That’s a very nice return on investment (ROI) for just a $150 investment.
Swaps contracts – Swaps, to put it simply, is placing a contractual ‘bet’ with another market participant that the value of an asset will fall, and when that happens, to ‘swap’ that for another one held by the other participant. Swaps work like insurance policies.
They allow purchasers to buy protection against an unlikely but devastating event. Like an insurance policy, the buyer makes periodic payments to the seller. Swaps do not trade on exchanges, and investors do not generally engage in swaps. They are traded over the counter, usually dealt through banks.
An example to make this clear – A mortgage holder is paying an adjustable (non-fixed) interest rate on their mortgage but expects this rate to go up in the future. Another mortgage holder is paying a fixed rate but expects rates to fall in the future. They enter a swap agreement.
Both mortgage holders agree on an amount and an end date and agree to take on each other's payment obligations. The first mortgage holder from then on will pay a fixed rate to the second mortgage holder, who then will receive an adjustable rate. By using a swap both parties effectively changed their mortgage terms to their preferred interest mode while neither party had to renegotiate terms with their mortgage lenders.
Contract for Difference – A Contract for Difference (CFD) refers to a contract that enables two parties to enter into a tradeable agreement based on the price difference between the entry prices and closing prices. As per the agreement, if the closing trade price is higher than the opening price, then the seller will pay the buyer the difference, and that will be the buyer’s profit.
The opposite is also true. That is, if the current asset price is lower at the exit price than the value at the contract’s opening, then the seller, rather than the buyer, will benefit from the difference. This will become clearer with this example: Let's say the initial price of Apple stocks is $100. You buy a CFD contract for 1000 Apple stocks. If the price then goes up to $105, the sum of the difference, paid to the buyer by the seller will equal to $5,000.
And vice versa, if the price falls to $95, the seller will get the price difference from the buyer equal to $5,000. The contract does not imply physical ownership or purchase/sale of the underlying stocks that enables investors to avoid the registration of the ownership rights for the assets and the associated transaction costs.
Credit derivative contracts – A credit derivative is a financial asset that allows parties to handle their exposure to risk. It consists of a privately held, negotiable bilateral contract between two parties in a creditor/debtor relationship. It allows the creditor to transfer the risk of the debtor's default to a third party.
Though the terms differ from one credit derivative to another, the general procedure is for a lending party to enter into an agreement with a counterparty (usually another lender), who agrees, for a fee, to cover any losses incurred in the event that the borrower defaults.
How the contracts work is it allows a lender or borrower to transfer the default risk of a loan to a third party. Though the terms differ from one credit derivative to another, the general procedure is for a lending party to enter into an agreement with a counterparty (usually another lender), who agrees, for a fee, to cover any losses incurred in the event that the borrower defaults.
If the borrower does not default, then the insuring counterparty pays nothing to the original lender and keeps the fee as a gain.
To better illustrate this, suppose XYZ Bank lends $10,000 (Dh36,732) to Bob for 10 years. Determining that Bob carries significant risk of defaulting as a borrower, XYZ Bank enters into a credit derivative with a separate ABC Bank.
The terms of the agreement state that in the event Bob defaults and is unable to repay the loan, ABC Bank will compensate XYZ Bank for the lent amount and interest due in return for an annual fee of $100 (Dh367) through the end of the 10-year term. If Bob does not default on the loan, ABC bank may keep the $100 annual fee as a gain.
How to trade derivatives?
Now that we have an idea of what derivatives are and what other types of derivatives are out there, let’s get down to how to trade in them and what makes it so difficult.
Derivatives can be traded in two distinct ways. The first is over-the-counter (OTC) derivatives, that see the terms of the contract privately negotiated between the parties involved (a non-standardised contract) in an unregulated market.
The second way to trade derivatives is through a regulated exchange that offers standardised contracts. This provides the benefit of having the exchange act as an intermediary, helping traders avoid the counterparty risk that comes with unregulated OTC contracts.
#PROs: Why to trade in derivatives?
Investors typically use derivatives for three reasons: to hedge (place bets) on a position, to increase leverage (meaning using borrowed capital for the investment while hoping profits made will be greater than the interest payable) or to speculate on an asset's movement (whether prices will go up or down).
Derivatives are typically used to protect investors from unforeseen price fluctuations, although they can just as easily lead to a financial loss. Derivatives traders must meticulously follow the markets in which they trade to assess the value of derivatives.
Derivatives are typically used to protect investors from unforeseen price fluctuations, although they can just as easily lead to a financial loss. Derivatives traders must meticulously follow the markets in which they trade to assess the value of derivatives.
For example, the owner of a stock buys a ‘put’ option (one type of option discussed earlier) if he or she wants to protect the portfolio against a decline. This shareholder makes money if the stock rises but also gains, or loses less money, if the stock falls because the ‘put’ option pays off.
Another advantage of derivatives is they are frequently used to determine the price of the core asset. For example, the prices of the futures can serve as an approximation of the price of the commodity it is going to be traded in worldwide.
Derivatives can also help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps (like the example discussed when defining what ‘swaps’ are), a company may obtain a more favourable interest rate relative to interest rates available from direct borrowing.
Instruments like forwards and futures allow companies that need material resources to plan their operations based on prices agreed on now for product or materials in the future. This allows a firm to have a firm grasp on its costs without having to make wild guesses as to the price assets in the future.
#CONs: What makes trading in derivatives risky?
Market volatility – Market risk refers to the general risk in any investment. Companies that produce or depend on the purchase of commodities are exposed to price fluctuations that occur in commodities markets. Examples of such companies include the airline industry, which is constantly exposed to the price of oil, and farming, which is not only exposed to the fluctuation in the price they can sell their goods at, but also the fluctuation in the price of animal feed, fertilizer, pesticides, and other such inputs.
Leverage risk – Another risk is also one of the things that makes them so attractive: leverage. For example, futures traders are only required to put a minimum of 2 per cent to 10 per cent of the contract amount into an account to maintain ownership (the broker lends the rest). If the value of the underlying asset drops, traders must add money to the account (called margin account) to maintain that percentage until the contract expires or is offset. If the commodity price keeps dropping, this can lead to enormous losses.
Time limit – Derivative contracts come with a specific time limit. The contracts expire as soon as the time duration is over. This may result in losses if the investments don’t work out in our favour in the specified time frame.
Speculative nature – Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses. Investors make decisions and take positions based on assumptions, technical analysis or other factors that lead them to certain conclusions about how an investment is likely to perform. The high volatility of derivatives exposes them to potentially huge losses.
Investors make decisions and take positions based on assumptions, technical analysis or other factors that lead them to certain conclusions about how an investment is likely to perform.
Counter-party risk – It is one of the major risks associated with derivative trading. It occurs when either of the parties in contract backs off or goes bankrupt. There is a high possibility of counterparty risk in over the counter trading than in exchange trading as over the counter trades are much less regulated.
Systemic Risk – Systemic risk pertaining to derivatives is widely spoken about. Yet it seems to be less understood and almost never quantified. Systemic risk refers to the probability of widespread default in all financial markets because of a default that initially started in derivative markets. In simple words, this is the belief that because derivatives are so volatile, one major default can cause cascading defaults throughout the derivatives market.
These cascading defaults will then spin out of control and enter the financial domain in general threatening the existence of the entire financial system. This view has been prevalent for a long time. However, it was often dismissed as a silly doomsday prediction. In 2008, most people found out that it wasn’t that silly and farfetched at all.
Complex choices – There are a number of complex derivative products, especially some types of credit derivative products and under the broader category of ‘swaps’ and ‘option’ derivatives, that are increasingly used to reduce the chances of major losses to an investor. A couple of common examples include ‘Credit Default Swaps’, ‘Total Return Swaps’ and ‘Mortgage-backed Security’. And yes, these are what makes it incredibly complex.
But before we go into details of what some of these are, to recap, we have so far touched base with what derivatives trading is all about and how someone new can go about it. For the significant risks flagged this can be a tough market for amateurs, which is why it has been advised that only people with high experience in trading should trade in the derivatives market.
For the significant risks flagged this can be a tough market for amateurs, which is why it has been advised that only people with high experience in trading should trade in the derivatives market.
We will now briefly go into the details of these complicated derivative options and shed light on the intricate workings. This is where most new investors find trading in derivatives turn increasingly hard, as the workings of the concept isn’t clear.
Tackling the complexities: What are the complex-yet-common types of derivatives?
• Mortgage-backed security: Mortgage-backed securities (MBSs) are simply shares of a home loan sold to investors.
How do they work? A bank lends a borrower the money to buy a house and collects monthly payments on the loan. This loan and a number of others -- perhaps hundreds -- are sold to a larger bank that packages the loans together into what is called a ‘mortgage-backed security’. The larger bank then issues shares of this assets, called tranches (French for "slices"), to investors who buy them and ultimately collect the dividends (returns) in the form of the monthly mortgage payments.
These tranches can be further repackaged and sold again, in what is called collateralized debt obligations (CDOs). It sounds innocuous enough, and it is. It's also an excellent and safe way to make money when the housing market is booming, but not so much when it’s not.
Similar to a bond? A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond annual interest payments (coupon payments).
Did you know? Home loans in 2008 were so divided and spread across the financial spectrum, it was entirely possible a given homeowner could unwittingly own shares in his or her own mortgage.
Similar to a bond? A mortgage-backed security (MBS) is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond annual interest payments (coupon payments).
The MBS is a type of asset-backed derivative. Despite them eventually being a factor that led to the crisis a decade ago, MBSs are still bought and sold today. There is a market for them again simply because people generally pay their mortgages if they can. The US Fed still owns a huge chunk of the market for MBSs, but it is gradually selling off its holdings.
• Credit default swaps: As bonds and other debt assets have a prevailing risk that the borrower will not repay the debt and because these often have lengthy terms like as much as 30 years, it is difficult for the investor to make reliable estimates about that risk over the entire life of the instrument. Credit default swaps (CDS) have become an extremely popular way to manage this kind of risk. (They are a type of credit derivative contracts, which was discussed earlier.)
So essentially, CDSs is a derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk.
But unfortunately, the swaps gave a false sense of security to bond purchasers in the past. They bought riskier and riskier debt. They thought the CDS protected them from any losses. What eventually happened was that during the financial crisis of 2008, the value of CDS was hit hard, and it dropped to $26.3 trillion by 2010 and $10 trillion at 2019-end.
In 2000, credit default swaps became largely exempt from regulation by both the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) - it is still being used, but heavily complex.
Since the crisis, CDS documentation and market practice has been tweaked almost beyond recognition, what matter experts now say it is like a “series of poor plastic surgeries”, there are more hazy conditions and exceptions in the paperwork, and more ways for participants to slip out of paying for the “protection” offered.
Did you know? Credit default swaps on Lehman Brothers debt helped cause the 2008 financial crisis. Lehman Brothers owed $400 billion in debt, which was "covered" by credit default swaps. That debt was only worth 8.62 cents on the dollar. They didn't expect all the debt to come due at once, and that’s what happened with the crash and Lehman declared bankruptcy.
• Total return swaps (TRS): Like credit default swaps, these are a type of credit derivative and off-balance sheet financing tool with the potential for tremendous leverage. Total Return Swap is a contract between two parties (let’s call them ‘A’ and ‘B’) who exchange the return from a financial asset between them.
What it means is, ‘A’ makes payments based on a set rate while ‘B’ makes payments based on the total return of an underlying asset. The underlying asset may be a bond, equity interest, or loan. However, in recent years, total return swaps are becoming more popular due to the increased regulatory scrutiny after the alleged manipulation of credit default swaps (CDS).
In a TRS contract, the party ‘B’ receiving the total return gets any income generated by the financial asset without actually owning it. It benefits from any price increases in the value of the assets during the lifetime of the contract. The receiver must then pay the asset owner the base interest rate during the life of the TRS.
The asset owner forfeits the risk associated with the asset but absorbs the credit exposure risk that the asset is subjected to. For example, if the asset price falls during the lifetime of the TRS, the receiver will pay the asset owner a sum equal to the amount of the asset price decline.
We can safely conclude that it’s not the actual practice of trading that is complex rather what goes on in the background – the (indeed!) truly-complex workings or the science behind it. (And yes, the blanket rule still stands, if you still don’t understand them, don’t risk putting your hard-earned money into it.)
