Derivatives offer investors a powerfulway to participate in theprice action of an underlying security. Investors who trade in these financial instrumentsseek to transfer certain risks associated with the underlying security to another party. Let's look at five derivative contractsand see how they mightenhanceyour annual returns.
Key Takeaways
- Five of the more popular derivatives are options, single stock futures, warrants, a contract for difference,and index return swaps.
- Options let investors hedge risk or speculate by taking on more risk.
- A single stock future is a contract to deliver 100 shares of a certain stock on a specified expiration date.
- A stock warrant means the holder has the right to buy the stock at a certain price at an agreed-upon date.
- With a contract for difference, a seller pays the buyer the difference between the stock's current price and the value at the time of the contract, should that value rise.
- An equity index return swap is a deal between two parties to swap two groups of cash flows on agreed-upon dates over a certain number of years.
1. Options
Optionsallowinvestors tohedge risk or to speculate by takingadditional risk. Buying a callor put option obtainsthe rightbut not the obligationto buy (call options) or to sell (put options) shares or futures contractsat a set price before or on an expiration date. They are traded on exchanges and centrally cleared, providingliquidity and transparency,two critical factors when takingderivatives exposure.
Primary factors that determine the value of an option:
- Time premium that decays as the option approaches expiration
- Intrinsic value that varies with the price of the underlying security
- Volatility of the stock or contract
Time premium decays exponentially as the option approaches the expiration date, eventually becoming worthless. The intrinsic value indicates whetheran option is in or out of the money. When asecurity rises, the intrinsic value of an in-the-money call option will rise as well.
Intrinsic value gives option holders moreleveragethan owning the underlyingasset. The premium abuyer must pay to own the option increases as volatility rises. In turn, higher volatility provides the option seller with increasedincome through a higher premium collection.
Option investors have a number of strategies they can utilize,depending on risktolerance and expectedreturn. An option buyerrisks the premium they paid to acquire the optionbut is not subject to the risk of an adverse move in the underlying asset.
Alternatively, an option seller assumesa higher level of risk, potentially facing an unlimitedloss becauseasecurity can theoretically rise to infinity. The writer or seller is also required to provide the shares or contract if the buyer exercises theoption.
There are a number of options strategies that blend buying and selling calls and putsto generatecomplex positionsmeeting othergoals or objectives.
Derivatives offer an effective method to spread or controlrisk, hedge against unexpected events, or buildhigh leverage for a speculative play.
2. Single Stock Futures (SSF)
A single stock future (SSF) is a contract to deliver100 shares of a specified stock on a designated expirationdate. The SSFmarket priceis based on the price of the underlying security plus the carrying cost of interest, lessdividends paid over the term of the contract.
Trading SSFs requires a lower margin than buying or selling the underlying security, often in the15-20% range, givinginvestors more leverage.SSFs are not subject to SECday trading restrictions or to the short sellers' uptick rule.
An SSFtends to track the price of the underlying asset so common investing strategies can be applied. Here are five common SSF applications:
- An inexpensive methodto buya stock
- A cost-effective hedge for open equitypositions
- Protection for a long equity position against volatility or short-term declinesin the price of the underlying asset.
- Long and short pairs that provide exposure to an exploitablemarket
- Exposure to specific economic sectors
Keep in mind these contracts could result in losses that may substantially exceed an investor's original investment. Moreover, unlike stock options, many SSFs are illiquid and not traded actively.
The last U.S. exchange to list single stock futures closed in 2020. Single stock futures continue to trade in modest volume on some overseas exchanges including the Eurex.
3. Warrants
A stock warrantgives the holder the rightto buy a stock at a certain priceat a predetermined date. Similar to call options, investors can exercise stock warrants at a fixed price. When issued, the price of a warrant is always higher than the underlying stockbut carries a long-term exercise periodbefore they expire.
When an investor exercises a stock warrant, the company issues new common shares to cover the transaction, as opposed to call optionswhere the call writer must provide the shares ifthe buyerexercises the option.
Stock warrants normally trade on an exchange butvolume can be low, generatingliquidity risk. Like call options, the price of a warrant includes a time premium that decays as it approaches the expiration date, generating additionalrisk. The value of the warrant expires worthless ifthe price of the underlying securitydoesn't reachthe exercise price before the expiration date.
4. Index Return Swaps
An equity index return swap is an agreement between two parties to swap two sets of cash flows on pre-specified dates over an agreed number of years. For example, one party mightagree to pay an interest payment—usually at a fixed rate based on a very short-term interbank lending rate—while the other party agrees to pay the total return on an equity or equity index. Investorsseeking a straightforward way to gain exposure to an asset classin a cost-efficient manneroften use these swaps.
Fundmanagers canbuy an entire index like the , picking up shares in each componentand adjusting the portfolio wheneverthe index changes. Theequity index swap may offer a less expensive alternative in this scenario, allowing themanager topayfor the swap at a set interest rate while receivingthe returnfor the contracted swap period.
They'll alsoreceivecapital gains and income distributionson a monthly basis while paying interest to the counterparty at the agreed-upon rate. In addition, these swaps mayhave tax advantages.
5. Contract for Difference (CFD)
A contract for difference (CFD) is an agreement between a buyer and a seller that requiresthe seller topay the buyer the spread between the current stock priceandvalue at the time of the contract if thatvalue rises.
Conversely, the buyerhas to pay the sellerif the spread is negative. The CFD's purpose is to allow investors to speculate on price movement without having to own the underlying shares. CFDs aren't available to U.S. investors but offer a popular alternative in many major trading countries, including the following:
- United Kingdom
- Germany
- Switzerland
- Singapore
- Australia
- Spain
- France
- South Africa
- Canada
- New Zealand
- Hong Kong
- Sweden
- Norway
- Italy
- Thailand
- Belgium
- Denmark
- The Netherlands
Note that some of the countries above may have heady restrictions.
CFDsofferpricing simplicity on abroad range of underlying instruments, futures, currencies, and indices. For example, option pricing incorporates atime premium that decays as it nears expiration. On the other hand, CFDs reflect the price of the underlying security without time decay because they don't have an expiration date and there'sno premium to decay.
Investors and speculators use margin to trade CFDs, incurring risk for margin callsifthe portfolio valuefalls below the minimumrequired level. CFDs can utilizea high degree of leverage, potentially generating large losseswhenthe price of the underlying security movesagainst the position. As a result, be cognizant of the considerable risks when tradingCFDs.
