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How does derivative trading work?

Jan 25 2010 13:05

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MONEY CLINIC recently asked the JSE to respond to questions from users about trading derivatives.

A Fin24.com user asks: How does derivative trading work?

The JSE responds: Futures, options and warrants are derivative products, meaning they are securities whose value is determined by or derived from other underlying assets like shares. Hence the term derivative instruments.

It must be noted that investing in derivatives is not for amateur investors on the JSE - it is better left to the more experienced investor as there is a greater amount of risk involved. You should first develop a successful track record with investing as well as a good understanding of the way derivatives work before entering these markets.

To understand derivatives trading better, let's take a look at how to trade a single stock futures (SSF) contract. You think a company will grow in the next few months.

Buying an SSF contract today allows the buyer to benefit from a favourable market without having to lay out the full capital cost of buying the underlying asset.

For example, one futures contract for an Company X share currently costs R4 500. One futures contract implies an exposure to 100 Company X shares worth R45 000 in the physical market. Any positive move in the share price during the term will clearly have more effect on the futures position (by virtue of its gearing effect) than on the physical position.

These future contracts are subject to margining, which means the investor has to pay a deposit upfront (usually the highest amount that can be lost in one day) to protect both parties should one party not hold his part of the agreement. Interest is earned daily on this margin, which is held by the exchange.

Secondly, the JSE re-values each position against the market price at the close of trade daily. This is done by calculating the fair value of the contract in question. This process is referred to as marking-to-market (MTM), with the fair value price being termed as the MTM price.

Any difference from the previous day's market price is either paid to the investor, or paid by the investor to the clearing house, in cash.

This payment is called variation margin.

In our example, let us assume that, at close of trade on April 25 2009 (the day after concluding the deal), the exchange establishes the closing price for a Company Y future to be R89.70.

This is deemed to be the MTM price on April 25 2006 for a September 2006 Company Y futures contract.

Since Broker ABC concluded a price of R87.96 for the buyer, this represents a positive movement for the buyer of R1.74 in the futures price (R174.00 per futures contract).

Conversely, this represents a negative movement of R1.74 for the seller of the futures contract. The exchange will require that the seller pay R174.00 into his margin account. The exchange will then pay this amount over into the buyer's margin account.

If you would like to ask specific questions about trading derivatives, contact the JSE's derivatives trading team on 011 520 7475, or email derivativestrading@jse.co.za.

- Fin24.com

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