In addition to the basic financial products covered in the previous lesson, you might have heard of more complex instruments, such as options and leveraged products. These investment products are not suitable for beginning investors because they come with a higher risk of losses. Nevertheless, this lesson will briefly introduce these products so you have a better understanding of the purpose they serve, and the risks that are involved.
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An introduction to derivatives and leveraged products
There is a wide range of financial products to choose from if you start trading, including very complex ones. Examples of these are options and leveraged products. These investment products are not suitable for the beginning investor, because they come with a higher risk of losses. However, we would like to briefly introduce them so that you better understand the risk involved.
Derivatives
If you are the owner of a stock, you also own a corresponding part of that company. But there are also investment products that derive their value from an underlying asset or product, such as a stock or commodity. These products are aptly named: derivatives. Experienced traders can use derivatives to speculate on price movements, or to hedge risk. Although derivatives can in some cases achieve a high return, they typically also come with high costs and risk.
Options
A common example of derivatives is an option contract. If you have a certain expectation about how the price of a stock will change, you can trade on this belief using an option. As the name suggests, options give you the right to buy or sell an underlying asset, like a stock, for a fixed price at a predetermined date in the future. A call option gives you the right to buy the underlying product while a put option gives you the right to sell.
Suppose the price of a stock is £20, but you expect an increase in the upcoming month. You can then buy one call option, giving you the right to buy this stock later, at a predetermined price. Say you choose an option that gives you the right to buy 100 stocks, for £21 each, two months from now. To obtain this right you pay a premium, £1,50 for example. This premium must be multiplied by a factor, which is the amount of stocks the option covers, often 100. If you purchase this option contract, the amount you invest would therefore be equal to £150.
If the price of the stock rises to £25 at the end of the 2 months, you can exercise the option, and open a position for 100 stocks at a price of £21 per stock. As the market rate is higher, you could directly obtain a profit by selling the stocks. Per share, you would then receive 25 euros from the sale. Taking the £21 purchase price and £1,50 premium into account, the profit comes down to £2,50 per stock, or £250 total. Had you used the initial investment of £150 to buy the shares directly, you would have got returns over 7 shares instead of 100, and profited less from the increase.
Futures
Another common type of derivative are Future contracts. Futures are standardized contracts which, like options, are made between two parties at a fixed price and expiry date. Unlike options, nearly all futures contracts are settled by cash payments, instead of the physical delivery of the underlying product at expiration. Also, the contract size tends to be bigger when compared to options.
Say you think a stock index will go up. It is currently priced at £600, and you consider a futures contract with a £200 multiplier. The whole value of this futures contract would be £120.000. When trading futures, you do not need to buy the whole amount, but typically put down an initial margin to enter into the contract. Say there is a margin rate of 15%. You would get a £120.000 exposure to the underlying, by making a deposit of at least £18.000 as margin to your account. This means you can get a large exposure for a small initial margin with a futures contract.
Unlike options, futures are settled on a daily basis. This means that if the future has gained 3 points at the end of the trading day, you will receive 3 times the £200 multiplier, for an amount of £600. Do note that because the contract size is bigger than the margin, it is also possible to lose more than your deposit with futures.
Leveraged products
There are also leveraged products which are issued by financial institutions that have varying names and characteristics. With these products you often borrow money from the product issuer in order to trade with increased exposure to an underlying asset and as such create a leverage effect. These products generally bear high cost within them, which are charged by the issuer. Examples of these products are warrants and certificates.
These products, as well as options and futures, are not suitable for the beginning investor because they are complex, volatile by nature, and risky. We’ve only covered the very basics in this lesson, and if you wish to trade these products it is strongly recommended to learn more about them before you start.
Coming up
The next lesson will examine what determines the prices of financial instruments, why they move, and how to differentiate between the different prices.
