ONCE you've gotten the hang of investing in stocks and bonds, what's next? Beyond those two common asset classes, there are in fact many other products that fall under the category of derivatives.
While they are more complicated, don't be too quick to rule derivatives out. After you've gained some investment experience, you may want to use them to access a wider range of markets and products. In the meantime, there's no harm checking out what derivatives have to offer.
What are derivatives?
A derivative is a contract between two or more parties based on an underlying asset. Some common underlying assets for derivatives include stocks, bonds, commodities, currencies, interest rates and market indices.
Derivatives are often used by traders to speculate on price movements of an underlying asset without having to directly own the asset. They can be used to boost trading profits, or to hedge against risks.
Before dipping your toes into derivatives on platforms regulated by the Monetary Authority of Singapore (MAS), you must undergo a customer knowledge assessment and meet one of the following criteria:
- have the relevant educational qualifications,
- have at least three consecutive years of relevant working experience in the past 10 years, or
- have the relevant investment experience.
If you don't meet any of those criteria, you can take the Singapore Exchange (SGX) Specified Investment Products online education module to better understand derivatives and earn the qualifications to trade in those products.
In general, financial institutions offering derivatives must also implement safeguards to protect inexperienced customers from large losses.
Such rules are in place because losses from derivatives can stack up quickly, given that derivative trading may incorporate leverage to boost returns.
This means that traders are able to take a larger position than the capital they have to deploy. Leverage amplifies both returns and losses.
Popular types of derivatives
- Options
Options give investors the right, but not the obligation, to buy or sell an asset by a specified date at an agreed-upon price, also known as strike price.
A call option gives you the right to buy a company's stock while a put option gives you the right to sell a company's stock. They can be used to hedge or speculate on the price of the underlying asset.
For instance, you own 100 shares of Company A's stock worth $10 per share. While you suspect that the share price might rise in the future, some uncertainty might linger.
One way to hedge against this risk is with options. You can buy a put option that gives you the right to sell 100 shares of the underlying stock for $10 per share - known as the strike price. If the stock does fall below $10, instead of losing money on your investment you will break even (excluding the cost of the options, of course).
On the other hand, if you are confident enough about the share price rising, you could buy a call option to buy a stock at the strike price. You are essentially locking in lower costs for an underlying asset you anticipate to increase in value in the future.
There is also an option to let the contract expire and walk away with no further financial obligation, with the exception of the fees and cost of the contracts.
- Contracts for difference (CFDs)
With an option, you make a profit by buying the right to buy or sell the underlying asset later. With a CFD, you will not be acquiring any assets. Instead, CFDs are just ways to speculate on the price of an underlying asset.
Trading of CFDs is done in two steps: an entry and an exit. If the underlying asset is up at the point you exit the CFD, the CFD broker will pay you the difference. If the underlying asset is down, then you will need to pay up.
In our hypothetical scenario above, let's assume you enter into the contract when Company A's stock is trading at $10. If you exit when the stock is trading at $12, the CFD broker pays you S$2. If you exit when the stock is trading at $8, then you owe the CFD broker $2.
CFD contracts typically have built-in leverage so you can make money even on small price movements of a few percentage points.
- Structured warrants
Much like an option, a warrant is a financial contract that gives the investor the option to purchase the company's stock at a specific price and by a specific date. Unlike stock warrants, which are issued by companies to raise money, structured warrants are issued by a third party.
As with options, there are both put warrants and call warrants. Structured warrants also have a conversion ratio that determines how many warrants you need to get one share. A conversion ratio of 5:1 means five warrants get you one share.
Structured warrants are listed on the SGX just like stocks so, unlike with options and CFDs, investors will not be faced with margin calls from their brokers.
A margin call happens when your potential losses exceed the initial amount you have invested by a certain percentage. Your broker will then ask for more money to top up your account.
Are derivatives for you?
Derivatives may not be suitable for everyone because they are more complex and would require you to be equipped with the right knowledge or experience to be able to manage the risks involved.
Unlike stocks and bonds, which give you a claim on a company and its cash or assets, derivatives are agreements with a third party. That means you are exposed to third-party risk - a risk that the third party cannot fulfil its obligations.
Also, derivatives incorporate various different forms of leverage. If you trade on margin, be sure you do not make a bet that you don't have the funds to make good on.
- This is the ninth instalment of Invest & Grow, a weekly 10-part series that aims to help new investors get started on their investment journey.
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