Ignorance can be dangerous when playing the investment game

While some financial advisors and brokers would have heard of stories where people had lost money trading derivatives, they also forget about the benefits that derivatives hold for financial advisors, their clients, other investors, and the economy as a whole.

 

Derivatives such as Single Stock Futures (SSF) are traded on an exchange, while Contracts for Difference (CFD) are traded over-the-counter (OTC). Derivatives that trade on the JSE are standardised contracts, while CFDs are contracts that are agreed upon privately between two parties, usually the client and the stock broking firm.

 

Although derivatives have risks, especially for the uninitiated, they also offer a great deal of value. Technically, they derive their value from the underlying instrument on which they are based, namely equities, but also commodities, currencies and financial indices. Derivative markets provide a range of opportunities for finance professionals as the explosion of trading strategies, as well as the increasing basket of derivatives to choose from, makes it more complicated for the private investor.

 

The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of such an investment within a portfolio strategy.

As a financial advisor or broker, your clients would typically use derivatives to either speculate on a security’s movement or to hedge a position. Speculating is a technique where traders decide on the future price or direction of a security. Because derivatives offer investors the ability to leverage their positions, large speculative positions can be executed at a low cost, which is one of the main reasons to get involved.

When the price of the underlying security moves significantly in a favorable direction, then the movement of the derivative is magnified. Your clients will trade more often, which translates into more recurring income.

 

On the other hand, hedging allows your client to take a position to protect their investments against adverse market conditions. Let us say for example, that you have clients that own shares in petrochemical giant Sasol. You want to help your clients by protecting them against the chance that the share price will fall.

 

Although you may anticipate the oil price to remain relatively stable over the medium term, you also think that the Rand will strengthen by a large margin, which will affect Sasol’s earnings going forward. You advise your clients to take short positions using SSF contracts to hedge their positions. In this case, if Sasol’s share price rises they gain on the shares but lose on the SSF position, because they own the shares. But if the share price falls, they also gain because they are short on the SSF.

 

The potential loss from holding the share is hedged with the single stock future contract, thus fixing the share price without having to liquidate the equity portfolio and possibly exposing the client to heavy taxes.

 

Most brokers and financial advisors love what they do. They all have different types of clients and investment objectives, but they share a love of markets and investment analysis. They make money by making their clients more money, which is a great feeling. Your clients expect that you will help them make money but more importantly, they like and trust you.