Derivatives have gained much popularity throughout the years since they were launched in the market. Here, we discuss about the four most popular derivatives that you should probably try. Read on!
Options
Options let investors hedge the risk or to speculate by taking additional risk. Buying a call or put option gets you the right but not the obligation to buy (call options) or sell (put options) shares or futures contracts at a set price before or at an expiration date. They are traded on exchanges and centrally cleared, offering liquidity and transparency, which are two critical factors when taking derivatives exposure.
The primary factors that determine the value of an option are:
- Time premium that “decays” as the option nears expiration
- Intrinsic value that varies with the price of the underlying security
- Volatility of a stock or contract
Single Stock Futures
A single stock future (SSF) is a contract to delivery 100 shares of a specified stock on a designated expiration date. The SSF market price is based on the price of the underlying security plus the carrying cost of interest, minus dividends paid over the term of the contract.
Trading SSFs requires lower margin than actually buying or selling the underlying security, usually in the 20 percent range, giving investors more leverage. SSFs are not subject to the Securities and Exchange Commission’s day trading restrictions or to the short sellers’ uptick rule.
Common applications include:
- A cheap method of buying a stock
- A cost-effective hedge for open equity positions
- Protection for a long equity position against volatility or short-term declines in the price of the underlying asset.
- Long and short pairs that provide exposure to an exploitable market.
- Exposure to specific economic sectors
Warrants
A stock warrant gives the holder the right to buy a stock at a certain price at a predetermined date. Similar to call options, investors can exercise stock warrants at a fixed price.
When issued, the price of a warrant is always higher than the underlying stock but carry a long-term exercise period before they expire. When an investor exercises a stock warrant, the company issues new common shares to cover the transaction, as opposed to call options where the call writer must provide the shares if the buyer exercises the option.
Stock warrants trade on an exchange but the volume can be low, generating liquidity risk. Like call options, the price a warrant includes time premium that decays as it approaches the expiration date, generating additional risk.
The value of the warrant expires worthless if the price of the underlying security doesn’t reach the exercise price before the expiration date.
Contract for Difference
A contract for difference is an agreement between a buyer and a seller that requires the seller to pay the buyer the spread between the current stock price and value at the time of the contract if the value increases. Meanwhile, the buyer has to pay the seller if the spread is negative.
The idea behind CFDs is to allow investors to speculate on price movement without having to own the underlying shares. CFDs are not available to US investors but offer a popular alternative in countries including Canada, Germany, the Netherlands, France, Japan, Singapore, South Africa, the United Kingdom, and Switzerland.
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