Share

Derivatives trading explained

Johannesburg - Derivatives is a buzzword that is often misused or misunderstood.

If you ask ten different asset managers or investors what a derivative is, you are more than likely going to receive just as many answers.

“Derivatives are financial instruments that derive their value from the values of an underlying variable: The ultimate payoff to the investor depends directly on the value of a variable,” explains Mabyanine Phiri, portfolio associate at ACM Gold.

“The financial market is a network where buyers and sellers trade financial instruments like shares of companies and derivatives."

The price of a company share is consolidated from the value, profitability and performance, amongst other factors, of that particular company that issued that share.

The price of a share derivative or exchange traded derivative, for example, is “derived” directly from that company share price,” explains Phiri.

Derivatives facilitate the management of financial risk exposure as they allow investors to transfer financial risk.

"In principle, derivatives markets could contribute to efficient asset allocation, create more opportunities for diversification of portfolios, price discovery, and more public information,” said Phiri.

“Derivatives can be privately negotiated over-the-counter or traded on organised exchanges such as the JSE, London International Financial Futures and Options Exchange (Liffe) and the Chicago Board of Trade."

The JSE trades derivative products mostly on the equity derivatives market, currency derivative market, commodity derivate market and on the interest rate market.

Futures contracts, forward contracts, options and swaps are some of the most common types of derivatives.

Participants in the derivatives market

“Participants in the derivatives market are hedgers, speculators or arbitrageurs who use derivatives markets for income enhancement," said Phiri.

Hedgers are entities (investors, lenders, borrowers, producers, manufacturers) that are exposed to the risk of adverse cash-market price movements.

Speculators attempt to make profits by taking a view on the market and if their views are right they make money and if wrong they lose money.

Speculators are willing to bear risk that others such as hedgers aim to avoid.

“For example, a European investor purchasing shares of an American company off an American exchange (using US dollars) would be exposed to exchange-rate risk while holding that stock," said Phiri.

To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros.

“It is important to note that trading derivatives comprises of major risks. One of the main risks is the possibility of losing more money than you started with," said Phiri.

"The risk of loss in trading futures contracts or commodity options can also be substantial and investors need to understand the risks involved in taking leveraged positions.”

Phiri said no one should trade derivatives unless they are experienced traders with the knowledge, risk control and financial capacity to trade such instruments.

"Derivatives traders require a high appetite for risk, time to watch the markets and an expert knowledge of the markets and trading process," he said.

"Although derivatives trading can be rewarding, it is important to carefully consider whether such trading is suitable for you in light of your circumstances and financial resources."

- Fin24

Do you have a pressing financial question? Post it on our Money Clinic section and we will get an expert to answer your query.

Disclaimer: Fin24 cannot be held liable for any investment decisions made based on the advice given by independent financial service providers.

Under the ECT Act and to the fullest extent possible under the applicable law, Fin24 disclaims all responsibility or liability for any damages whatsoever resulting from the use of this site in any manner.

We live in a world where facts and fiction get blurred
Who we choose to trust can have a profound impact on our lives. Join thousands of devoted South Africans who look to News24 to bring them news they can trust every day. As we celebrate 25 years, become a News24 subscriber as we strive to keep you informed, inspired and empowered.
Join News24 today
heading
description
username
Show Comments ()
Rand - Dollar
18.94
-0.0%
Rand - Pound
23.91
-0.0%
Rand - Euro
20.42
+0.1%
Rand - Aus dollar
12.33
+0.1%
Rand - Yen
0.13
-0.0%
Platinum
908.05
+1.2%
Palladium
1,014.94
0.0%
Gold
2,232.75
-0.0%
Silver
24.95
-0.1%
Brent Crude
87.00
+1.8%
Top 40
68,346
0.0%
All Share
74,536
0.0%
Resource 10
57,251
0.0%
Industrial 25
103,936
0.0%
Financial 15
16,502
0.0%
All JSE data delayed by at least 15 minutes Iress logo
Company Snapshot
Editorial feedback and complaints

Contact the public editor with feedback for our journalists, complaints, queries or suggestions about articles on News24.

LEARN MORE
Government tenders

Find public sector tender opportunities in South Africa here.

Government tenders
This portal provides access to information on all tenders made by all public sector organisations in all spheres of government.
Browse tenders