Taking a gamble on derivatives

Why are performance measurers so interested in derivatives? Why don't we treat them like any other asset class or security? Are they really different? These are some of the basic questions most of us hear, if not daily, then fairly frequently. Let us list some of those reasons.

Ownership of asset is one reason that springs to mind. When we go long on an equity security, you own some of the share capital of that company. Most of us will have heard of the 'three per cent rule' and the notifying interest in a company or where 30 per cent ownership of a share capital is breached and a takeover bid becomes enforceable. However small or large, you are buying or selling ownership. This does not occur so transparently or obviously with derivatives. Let's explore why.

Investing in options confers the right - but not the obligation - to make or take delivery of the asset. You may own the asset, at some stage in the future, but you do not own it yet. If an investor buys a call option for a premium of 30p with a strike price of 100p, then until the option is exercised, ownership of the underlying security does not come into play. Of course, the investor in this conventional example, will not exercise unless the stock price reaches 130p or more. Alternatively, they may wish to just deal in traded options and try to add value on the premium without committing themselves to physical ownership.

The challenge for performance measurers is to recognise the issue of ownership and to reflect accurately the economic impact of any derivatives position. The approach recommended is to use associated economic exposure. This reflects the full potential upside and downside to any derivatives position, and attempts to show accurately, value at risk. I'll use some examples later to show how this works.

Derivatives are used as a method of introducing 'leveraging' into a portfolio. Leveraging is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. It comes with greater risk and magnifies both gains and losses in investment performance. A clear example of leveraging can be seen when analysing the impact of a contract for difference (CFD). If you wish to buy 50,000 shares in a company worth £1 each, and an underlying exposure of £50,000, an alternative and cheaper way of gaining that exposure is to buy a CFD. If the margin requirement or NTR (Notional Trading Requirement) is 10 per cent, then you only have to commit £5,000. Basically, spending £5,000 has gained you £50,000 of economic exposure. You have leveraged your position by a factor of 10. Meanwhile, the share price of the company has increased to £1.50 from £1. The investor, at this point, enjoys an unrealised gain of £25,000 as he takes the gain or loss on the full economic exposure of the shares, ie, £50,000 and not his committed value of £5,000. Of course, there is a downside to this position. If the share price drops to 10p, then the investor is facing an unrealised loss of £45,000 rather than £4,500. The investor faces losing much more (maximum of £50,000) than was committed to the deal (£5,000). As an individual, you may start losing money you don't have. This is different to standard long-only styles on investing, when you only lose what you've invested originally. If I purchased £50,000 worth of shares, without using a CFD, then presumably, I only stand to lose what I invested.

Another approach to this scenario is to look at the difference between fixed-odds and spread betting. If I decide to take my leave one afternoon for an afternoon's racing at Kempton Park, I'd presumably take my chances with the rail bookmakers. For the first race, I stake £10 on a 7/1 chance. Let's look at my win/lose scenario. My maximum upside is £70, with a limited downside of £10. As no credit facilities are available, I can only lose what I already have (ie, £10). Try to think of this in a standard long-only equity investment, as in either example, you can only lose what you have staked. The only difference is the upside: unlimited in an equity stake, but limited to £70 in my racing example, albeit this can be construed as variable according to the price of my bet.

The flipside to fixed-odds betting is spread betting. Spread betting is regulated by the FSA (formerly regulated by Securities and Futures Authority) and akin to taking out highly leveraged derivative positions. I could take a football bet on buying championship points for Ipswich for the season. They play 46 games a season, so we're talking about a maximum position of 138 points (46x3) or zero points (they lose every game). A market maker quotes a spread of 77-80, so you either buy at 80 or sell at 77. I buy Ipswich points (80) at £100 per point. What is my potential upside? If Ipswich win every game, and reach 138 points, it is 58 (138 minus 80) x100=£5,800. What is my potential downside? If Ipswich lose every game, it comes to 80x100=£8,000. The key point to remember here is that I can place the bet, so long as I have an account, without having to place any money over to the market maker. The only money transacted, is the 'netting-off' to close a position (Occasionally, on a very large deal, some initial margin may be placed). What does all this mean? First, I can win or lose a great deal of money. Secondly, I can be at risk to lose more money than I may potentially have. Last, my bank balance, albeit at the moment, is unaffected. You are deferring payment.

What I have tried to do with these two examples? I have tried to show the contrast between standard long-only style investments Ð you have to match the entire initial exposure in physical cash, and your maximum downside is your stake and derivatives, where you are exposed to much more than your, if any, initial stake. Long-only traditional investments versus derivatives are like fixed-odds versus spread betting.

Margin payments are another defining feature of derivatives. Why are they used? Essentially, they are used as a form of insurance or either a means of settlement. They can form a down payment against the exposure taken out by a derivatives position, as with contract for differences. Alternatively, they can be a method of settling movements, on a day-to-day basis, for underlying movements in economic exposure as with futures. Margin is irrelevant in the context of standard, long-only investments.

Why would you need it? You have a physical asset that appreciates, depreciates or remains unchanged. Profits and losses are unrealised, until settled. There is no real risk (subjective?), other than in losing, as explained before, money you already have.

Finally, one remaining feature of derivatives is to hedge exposure. They can provide an efficient, convenient method of gaining access to an asset class. For example, an index futures gains you market exposure, if not perfect return correlation. You can increase/decrease your asset exposure without having to go through the procedure of buying/selling individual securities. Potentially, using swaps means that you gain exposure, where previously, liquidity issues have made this difficult. Of course, you need a willing counterparty.

So how do we conclude a discussion on derivatives? We've seen their basic properties, and how they differ to conventional investments. We can use derivatives to reduce or increase risk, by manipulating leverage. Derivatives can facilitate a quick and convenient way of achieving exposure. And, we can 'short' positions to produce positive absolute returns and alpha. Falling markets does not mean we have to 'run for the hills'. We can still make money. Therefore, they are surely an investor's dream.