Should individual investors use derivatives?

Derivatives are often considered to be at the exotic end of the investment spectrum, but in fact they have a wide range of uses within a portfolio. They can super-charge the performance of an investment portfolio – or, indeed, magnify its losses – but they also enable well-informed investors to hedge risk or amend the payoff of investment.

In many cases derivatives are complex, and some involve leverage, delivering the same effect as borrowing. This is good if the investor’s skill and judgement pays off, but if not, it can leave individuals nursing heavier losses that they would otherwise incur. Deployed with skill, they can be a useful tool.

Derivatives are financial instruments based on an underlying asset. Mainstream derivatives such as futures and options may be used with the aim of generating higher returns, or to hedge a portfolio against market fluctuations.

Derivatives are financial instruments based on an underlying asset. Mainstream derivatives such as futures and options may be used with the aim of generating higher returns, or to hedge a portfolio against market fluctuations. They can be traded on-exchange, through futures and options exchanges such as Eurex and Euronext, and also through over-the-counter transactions in which the terms are agreed between the two parties.

Options

An option is a widely used and recognised form of derivative contract, giving investors the right (but not the obligation) to buy or sell a particular security or benchmark – such as a share, a bond, or a market index – at a given price at a future point in time.

For example, one party may agree to sell 1,000 Volkswagen shares at €150 in six months’ time. If the price is €160 when the time is up, the buyer is likely to exercise the option because they can buy the shares lower than the prevailing market price and make an immediate profit.

If the price is €145, they will not exercise the option, which will lapse. The option seller will have received a ‘premium’ – the price of taking out the option – and keeps the shares.

An option to buy a security is known as a ‘call’, and is essentially for the buyer a way of betting that the security’s price will rise, while an option to sell, known as a ‘put’, is for the seller a bet on the fall in its price.

Covered versus uncovered

Options can be covered or uncovered. In the case of a covered option, the issuer owns the underlying asset that they are offering to sell, which means their risk is limited. The potential loss for the buyer of the option is limited to its cost, the option premium. The seller could suffer an opportunity cost if they could have sold the shares at a higher price, although this is mitigated to some extent by the option premium they have received.

Uncovered options are a different type of investment, and considerably riskier.

Selling covered call options (sometime referred as call overwriting strategy) are widely used by fund managers to enhance the return from their portfolios by obtaining option premiums, which add to the fund’s income, although they potentially surrender some of the upside growth in the value of shares.

Uncovered options (also known as naked option) are a different type of investment, and considerably riskier. Because the underlying asset could in theory increase indefinitely, selling uncovered call options involves unlimited risk.

Options can be issued on all types of asset, including shares, indices, currencies and commodities. They also have uses in the wider economy: an oil company may use an option to manage the price it gets to sell it’s crude production, or an airline to obtain certainty about its future fuel costs.

In practice, most companies exposed to volatile bulk commodity prices use derivatives of some kind to hedge their exposure to sharp prices changes. Companies with large pension schemes may use financial derivatives to hedge their exposure to fluctuations in financial markets. However, a significant portion of the market consists of trading by speculators who use options to bet on the rise or fall in the price of particular assets or the embedded parameters of option pricing (known as the “Greeks”).

How warrants differ from options

Warrants operate like options in that they give the right, but not the obligation, to buy or sell a security. A major difference between stock warrants and stock options is how they originate. Stock options are listed on exchanges, whereas stock warrants are issued by a company (the underlying company or a financial intermediary). When a stock option is exercised, the shares of the stock are received or given from one investor to another. When a stock warrant is exercised, the shares of the stock are received not from another investor, but from the company itself. Companies issue warrants mostly to raise capital. When stock options are exchanged, the company itself does not make any money from those transactions.

Warrants tend to longer term by nature, with a longer gap between issue and expiry. When the warrant is exercised, its holder receives newly-issued stock, rather than existing shares, as is the case for options, so the transaction dilutes the holdings of existing shareholders.

Investors use warrants as a means of taking a larger exposure to a security such as a company’s share, but they can also be used to hedge against a fall in price, or to exploit arbitrage opportunities.

Investors use warrants as a means of taking a larger exposure to a security such as a company’s share, but they can also be used to hedge against a fall in price, or to exploit arbitrage opportunities.

Turbo warrants

There are various different types of warrant. Popular in certain parts of Europe are so-called turbo warrants. Turbo are contingent in nature in the sense that if the price of the underlying instrument touches a predefined point (barrier) during the product life, the warrant is terminated ahead of maturity without any right and value. It is commonly said that those warrants have a knock-out barrier.

While normal warrants are sensitive to a mix of volatility, the price of the underlying asset, and market conditions, turbo warrants are particularly affected by short-term volatility. They tend to offer a smaller choice to investors, being issued on large global blue-chip company shares, as well as major equity indices such as the FTSE 100, CAC 40, DAX and Eurostoxx 50.

Covered warrants are traded on margin, which means traders can employ leverage – the higher the leverage, the greater the risk. If a trader employs 50 times leverage, they stand to lose 50% if the price of the underlying asset drops by 1%. This could cause a lot of money to be lost very quickly, but turbo warrants usually incorporate a stop-loss mechanism that protects investors from losing more than their initial margin payment.

Warrants, options and other derivative instruments such as futures have a place in a portfolio to target specific exposures and mitigate identified risks in a way that is not always possible with conventional securities. However, they are complex and can be a quick way to lose money for the inexperienced.