Chapter 2, Lesson 2: Financial Instruments – Part 3: Derivatives

Derivatives

Forward Contracts

A forward contract stipulates that one party will sell another party an underlying asset at a specified time for a specified price. These contracts are non-standardized, meaning the terms pertaining to the asset vary from contract to contract. The date on which the asset changes hands is known as the ‘spot date’. The price at which the underlying asset will be traded is known as the ‘forward price’, and the price at which the asset is trading on is the ‘spot price’. The seller of a forward contract is taking a short position and assumes the price of the underlying asset will decrease. The buyer, on the other hand, is taking a long position and assumes the price will increase. If the price increases, the buyer can make a profit, and if it decreases, the seller makes the profit.  Forward contracts are over the counter, meaning they are not traded on an exchange, and therefore are less relevant to retail investors.

Futures Contracts

Futures contracts are much like forward contracts, except that they are traded on an exchange. The underlying asset of a futures contract is standardized in terms of quality, quantity, etc. In addition, futures exchanges require traders to keep a cash account with the exchange, known as a ‘margin’. Because there is a risk of one party defaulting on the contract, the exchange requires both parties to maintain a margin account, which is simply a cash account. When buying futures, the buyer must have a percentage, set by his broker, of the contract’s value in a margin account to buy the contract. It is also this account from which the exchange settles profits and losses on a daily basis. Thus, by the spot date, the price of the underlying asset being exchanged is equal to the spot price, and the profits and losses of each party have already been accounted for. This process is known as marking the market, and protects all entities involved in the trade from the risk of a defaulting party. Most futures contracts are not held until their spot date and are instead sold after realizing a sufficient profit, or to cut losses. This can be done without too much worry thanks to the high liquidity of futures contracts due to the fact that they are traded on exchanges. Futures are one of the most popular derivatives and essential to commodities and Forex trading (more on Forex trading later), but the majority of future contracts having financial products, such as indexes, as their underlying assets.

For example, a September 15, 2015 S&P 500 futures contract (meaning the spot date is September 15, 2015 and the underlying asset is the S&P 500 index) is currently trading at 1,975.51 points (points are simply a quantitative measure of the performance of the index, in this case the S&P 500). An S&P 500 futures contract trades at $50 times the point value of the S&P 500 for that date. Thus, one September 15, 2015 S&P 500 futures contract is worth $98,775.50 USD. Your brokerage only makes you put 5% of the contract value in your margin account to purchase the contract, thus you must have a minimum of $4,938.78 in your margin account to hold the contract, and you put in $5,000. You expect the S&P 500 to be trading above 1,975.51 points by September 15, 2015. Now let’s say it’s September 1, 2015 and the S&P 500 is now at 1,968.32 points. This means you have lost $359.50 (50*[1,968.32-1,975.51]). After receiving margin calls and subsequently replenishing your account, you now decide to cut your losses and close your position. By doing so, you are returned the value of your margin account, equal to the initial $5,000 you put down to be able to buy the contract. This is because the amounts you deposited to replenish your account are equal to the $359.50 you lost. Now, it is important to understand that when you buy a futures contract, the money you put in your margin account to pay for it is like a down payment, and the rest is of the value is paid on margin (borrowed money). In addition, you pay for the losses or gains on a daily basis. Thus, when you decide to close your position, you do not exchange cash with the new buyer, and you simply transfer ownership of the contract and are refunded your ‘down payment’. And finally, when you transfer ownership of the contract to another person, you do not assume the selling side of the contract and receive payment if the price goes down, you are simply transferring the rights to buy the underlying according to the terms of the contract to someone else.

Spot Contracts

A spot contract states that a buyer will receive delivery of the underlying security, currency, or commodity, before the spot date (the date of payment), typically immediately. The price paid on the spot date, the delivery date, and all other terms are agreed upon prior to payment, along with the trade of the underlying. In short, get it now and pay later.

Options Contracts

Option contracts give the owner the option (the right, but not the obligation) to purchase an underlying asset for a specific price (strike price), before or on a specific date (expiration).

There are two types of option contracts: call options and put options.

Call options give the buyer the option to buy the underlying, and put option give them the right, but not the obligation, to sell the underlying. Thus, selling a call means you give someone else the right to buy the underlying from you, and by selling a put you are giving someone the right to sell you the underlying; all within a certain period of time for a specific price. Purchasing the underlying having bought a call, and selling the underlying having bought a put (stay with me here, I know this can get confusing, and reread that last bit if you have to), is known as ‘exercising an option’. Most option contracts aren’t exercised because the contracts typically have value themselves. This value is expressed as the price of the contract (option premium), per unit of the underlying. An option’s value is determined by various models, most often the Black-Scholes model. The two components in option pricing are its intrinsic value and its time value. Intrinsic value for options contracts is different than that of securities and assets. For a call option, the intrinsic value is the difference between the underlying assets current market price and the strike price. For put options, the value is the difference between the strike price and the underlying’s current market price. If the intrinsic value is zero or negative, its intrinsic value is zero. Thus, intrinsic value can be interpreted as the profit the buyer of the call would make (without figuring in the option premium) if they sold the option at that point in time. Next, the time value is essentially the value of the time the contract has to be in the money upon maturity. When something is in the money, it yields a profit. Where something is in the money varies from contract to contract. For call options, it is above the strike price, and for puts, it is below the strike. This is because buyers of calls want to buy the underlying at a discount from the current market price they will sell at, and buyers of puts want to sell the underlying for more than the current market price. Sellers of both calls and puts want the price of the underlying to stay out of the money (remember this has different meaning for calls and puts), so that the buyers won’t exercise the option. Sellers of calls and puts just want to receive the option premium and not have to give up their assets (in the case of a call seller) or cash (in the case of a put seller).  Coming back from that necessary, but long tangent, the more time you have for your option to be in the money, the more expensive the option will be if all other factors remain the same as when it was purchased. Conversely, the closer an option is to maturity, the less expensive it will be if all other factors remain constant. This phenomenon is known as ‘time decay’.

The components of option price are made up of various factors, including: price of the underlying, volatility (typically determined by past price movements), the strike price, the amount of time until expiration, and lastly, interest rates and dividends. Most options traders trade the options themselves. Options trading is much less expensive than trading other instruments, and can provide much lower risk if used properly.

Contracts For Difference (CFDs)

A CFD is basically a contract between the broker and the buyer which trades as an instrument itself and tracks the price of an underlying security, though the underlying is never bought or sold. The underlying can range from stocks to commodities to indexes, and more. Like futures contracts, this is achieved by using a high degree of leverage, allowing for only 5% margin needed to engage in the trade. Therefore, if you bought a CFD with 100 shares of a $58.62 stock as the underlying, you might only pay $293.10 instead of $5,862.00. Not bad! And if the stock rises to $62.44, you earn the full $382.00 if you sell at that price. Ah, the beauty of margin. But be careful – margin calls can cause you serious trouble and I do not suggest entering into trades with margin until you feel you have enough experience and are comfortable with doing so. Also, with margins, losses will be to the same degree as earnings if the price decreases and you hold a long position, etc.

CFDs are great instruments because there are often few, if any, fees and you still enjoy professional broker services (of course, broker credibility is up to the investor to investigate and verify). Instead, brokers earn from CFD trades by taking the spread of the underlying as their form of payment. The spread is the difference between the ask (the lowest any seller is willing to take for the underlying) and the bid (the most any buyer is willing to pay). The spread of a CFD is usually more than that of the the underlying in the market, due to less liquidity in the CFD market. Therefore, if the CFD is bought when the ask reaches $58.62 and the bid is $58.58, the broker will charge a bit over $4.00 ($0.04 multiplied by 100 shares) for the trade. The CFD must be sold at the current bid, which, again, will usually be lower than that of the underlying in the underlying’s market. To break even, the underlying will have to appreciate by the amount of the original spread. This limits the amount that can be made from small movements in the underlying’s price, but day traders will be happy to hear that there are no requirements to day trade and accounts can be opened with as little as $1,000.00.

Swaps

Swaps are quite possibly the coolest, most interesting instruments and you will probably never encounter them as a retail investor. Swaps are contracts which stipulate the exchange of one financial instrument for another, between two parties. Why I find them so interesting is the math behind their trading and the fact that both parties can profit, unlike most other instruments where the correct party reaps the losses of the wrong party. Even though one party might be selling a financial instrument worth more than the instrument they are receiving, both parties will profit if the math is performed correctly. This is because different instruments have different effects on different owners. For example, TechnoCorp is a large international company with many operations in Pagnahn, a developing country with a manufacturing and export based economy. TechnoCorp produces most of its products in Pagnahn, where it can have its products made by skilled labourer’s and pay them low wages. It must pay these wages in nahn, the local currency, and this exposes it to potential losses because it, and many other international companies employing Paghnani labourers, must exchange the dollars it makes in its main market to nahn, and by buying nahn they are increasing the demand, and thus driving up the price. Pagnahn wants to keep its currency at a low price so that foreign companies will continue to employ its factory workers. Thus, Pagnahn’s central bank could enter into a swap trade with TechnoCorp, and similar swap trades with many other multinational corporations, wherein the PCB engages in a series of exchanges of nahn for TechnoCorp’s main market’s dollars, at a specific rate that will not be influenced by exchange rates. Instead, to simplify things, it enters into a swap contract with TechnoCorp and the other multinationals where it agrees to pay the difference of the cost of their buying nahn and what the cost would be at the agreed upon exchange rate. This process is known as netting. Now, the PCB does not have to worry about the multinational companies employing its factory workers and funding its economic boom going anywhere anytime soon. TechnoCorp benefits too. It can pay its Pagnahni workers without having to worry about driving up the price of the nahn, and can thus limit its expenses, saving it money for itself and ensuring future profitability.

That’s a wrap! Now you have learnt a thing or two about all the financial instruments, and next we will briefly examine what organizations and entities that make up the financial world.

Up next: Chapter 2, Lesson 3: Financial Organizations


Sources:

Image: J. R. Eyerman, LIFE magazine.

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