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Derivatives A fresh approach to financial independence for women Contents What is a Derivative? 3 CFDs 4 Options and Futures 15 Interest Rate Swaps 25 Disclaimer Unless specifically stated otherwise, any information contained in this ebook is for information purposes only and is not intended to be financial advice as it has been prepared without taking into account your financial objectives, financial situation or needs. Before acting on any information in this ebook, Ethical Financial Services Pty Ltd recommends that you consider whether it is appropriate for your circumstances. 2 Derivatives What is a Derivative? There are many different kinds of derivatives. We can only give you a general introduction here. Let’s look first at the definition of a derivative: A derivative is a financial instrument that "derives" its value from the intrinsic value and/or change in value of an underlying asset. Examples of derivative trading instruments are - CFDs, call options, put options, interest rate swaps, futures contracts, etc. In general, derivatives are used by sophisticated investors to maximize cash returns and/or minimise negative exposure to uncertain price movements in the underlying asset. They can also be used by corporations to manage and control commodity supply cost and the sensitivity of net cash flow to changes in variables like interest rates, commodity prices, liquidity, etc. Wikipedia defines derivatives as follows: "A derivative is a financial contract whose payoffs over time are derived from the performance of assets (such as commodities, shares or bonds), interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) or an index of weather conditions)." With a derivative, you are neither buying part of a company, as with a stock, nor lending to a company, as with a bond. Instead, you are making some other kind of bet or deal with some other party where the payoff depends on what some asset (or rate or index) will do in the future. Derivatives are not for everyone. Derivatives are becoming increasingly popular as tools to transfer ownership risks. They can be used to hedge, or reduce risk, or they can be used for speculation, offering a lot of risk for the possibility of a big reward. 3 Derivatives CFDs Contracts for Difference (CFDs) are the fastest growing tool in the financial services industry for trading in shares, foreign exchange, and commodities such as gold and oil. Investors and traders from all backgrounds and levels of experience are now using CFDs to increase their returns and better manage their risk. You MUST understand that CFD Trading is a dynamic pursuit, with traders needing to stay on top of multiple information streams at any one time to get the best results. What is a CFD? A Contract for Difference (CFD) is a contract between two parties to exchange the difference in the price of a security from the open and close of a contract. CFDs are a leveraged product and require a trader to deposit a fraction of the total value of the position (known as margin) to open a position. The profit & loss is determined by the difference in the entry and exit price of the underlying instrument from when the contract is opened and closed. CFDs have been used by professional investors for over twenty years and first emerged in the over-the-counter (OTC) or equity SWAP market. Equity swaps were used by institutions to cost effectively hedge their equity exposure. CFDs have become one of the most popular derivative products in the last 3 years. Their popularity has been fuelled by the advantages that they can offer retail clients: • Leverage: CFDs enable you to obtain full exposure to a share for a fraction of the price of buying the underlying instrument. CFDs require only a small initial margin as a trading deposit. However, leverage, usually involves more risks than a direct investment in the underlying instrument. It is important to understand that leverage can work against you, as well as for you. Using leverage magnifies both your trading profits and losses. 4 Derivatives CFDs • Through CFDs you can potentially profit from either a rising or falling market. This can be done by taking long or short positions over selected shares, indices, foreign currency pairs and commodities. • CFDs can be used to go ‘short’- CFDs allow you to sell shares you don’t actually own. With a short position, you'll receive the full benefit of any fall in the share price. • Low transaction costs: CFD providers pass on volume discounts allowing you to benefit through lower transaction costs. CFDs are a competitive and liquid financial instrument. • Hedging: CFDs allow you to employ more advanced strategies such as hedging your existing share portfolio. • Simplicity: CFDs mirror the price of the underlying instrument. You can hold a position as long as you like. Unlike Options trading, there's no expiry date or time decay. You'll never have to take delivery of the underlying securities. You can also trade them online or over the phone. • Dividends and Corporate actions: When you take a ‘long’ position CFD, you can enjoy the same dividends and capital growth as ordinary shareholders, but with an outlay of only around 5% of the cost of the shares. CFDs give you the transparency of a regulated market. 5 Derivatives CFDs There are two different CFD models: Direct Market Access (DMA) and Market Making. The difference between these models relates to the way in which the prices are derived and how orders are placed between yourself and the CFD provider. Direct Market Access (DMA) In this scenario your CFD order is placed directly into the real underlying market. This results in real time execution, true market prices, participation in the order book and opening and closing phases of the market. Transparency is a key ingredient of the DMA CFD market. All CFD orders are transacted in the underlying cash market, ensuring complete pricing transparency. All trades are executed on a strict price/ time priority. Price/time priority means the first person to enter the best price is traded against first. As such everyone in the central market order book is treated fairly and consistently, no matter how big or small the trader. All market information reflects the cash market. This DMA model of CFD trading is no different to trading shares using leverage. Market Maker Model. Some CFD providers use a market maker model by which you trade on synthetic prices that could potentially be different from the real prices of the underlying shares. Market Makers base their prices on those offered in the physical market, but as a middle man they have the flexibility to move prices as they see fit. This can cause slippage which can become a significant cost of trading. A market maker will often state that they ‘mirror the price’ rather than actually matching the price. This results in orders being filled at inferior prices. Market makers do not hedge 100% of their CFD positions and make money when you lose money. When trading through a market maker your orders are at the discretion of a dealer. Your CFD order is not placed directly on the market, so trading can be slower, especially in fast moving markets. 6 Derivatives CFDs Features of a CFD To gain a thorough understanding of the mechanics of CFDs it is important to become familiar with the key features of the product. CFDs are traded on margin. Therefore it is essential that you understand what this means. What is a margin? A margin is a deposit used as collateral to fund a CFD position. There are two different forms of margin that may be payable when trading CFDs: 1) Initial Margin An Initial margin is a deposit used as collateral to open a CFD position. The margin is held to ensure you can meet your obligations. A margin rate is expressed as a percentage and is calculated based on the liquidity and volatility of the underlying security. Margin rates typically range between 3% – 100%. The margin requirement is calculated using the mark to market concept; meaning the current value of your position is assessed during each trading day. The margin required is adjusted to reflect the current market value of the position as the price of the underlying security fluctuates. Additional margin amounts will be payable should you fail to maintain the required margin on your position. 7 Derivatives CFDs Calculating an Initial Margin. Example: You wish to buy 1,000 Share CFDs at $10.00 The Share CFD has a 5% margin requirement 1,000 x $10.00 = A$10,000 (this is the total value of the trade) A$10,000 x 5% = $500 $500 is the initial margin requirement for this trade. 2) Variation Margin In addition to the Initial Margin required to open to hold a CFD position, you may also be required to pay an additional margin incurred by an adverse price movement in the market. This is known as Variation Margin. For example, if you have a long position and the price falls then you are required to pay a Variation Margin large enough to cover the adverse movement in the value of your position. Conversely, if you have a short position and the price falls, you would receive a Variation Margin equal to the positive movement in the value of the position. Failure to pay a Variation Margin call can lead to the position being compulsorily closed out. You as the position holder are obliged to pay for any shortfall in funds if Variation and Initial Margins are insufficient to cover the shortfall.
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