What are derivatives? 

Before we consider the effectiveness of derivatives it is important to understand the different types. Derivatives are investment instruments that derive their value from another underlying asset, such as shares, currencies or an index. There are many different kinds of derivatives, such as futures, options and swaps. Derivatives can be listed or unlisted (over-the-counter (OTC)) instruments. Examples of listed derivatives are futures, option on futures and warrants. Examples of unlisted derivatives are contracts for difference (CFDs), forwards, OTC options and swaps. The difference between listed and unlisted derivatives is that listed derivatives tend to be standardised (for example futures) whilst OTC derivatives can be tailored to an investor’s specific needs (for example forwards). OTC derivatives also result in the investor having credit exposure to the derivative provider. This is not the case for listed derivatives. 

Is there a place for using derivatives when considering investing?

Derivatives can be an effective hedge to protect an existing share portfolio, considering the types of risks inherent in investing, namely market risk (the risk that share prices will increase or decrease in line with market moves) and currency risk (the risk that the rand will weaken or strengthen against global currencies in response to macroeconomic events locally and globally). 

Using derivatives as a hedge to provide protection to an existing share portfolio against adverse market movements can be achieved through different derivative contracts. You can enter into a derivative transaction to hedge a particular share within your portfolio, or the derivative transaction can reference an index to provide a hedge against market movements on the whole. It is important for investors to understand the concept of entering into a long or a short contract, as they provide different types of protection against market movements. Entering into a short derivative contract referencing a single stock enables the investor to protect against future downside specific to that stock. Listed single stock futures or a CFD referencing the share will achieve this protection. 

Where investors enter into a long position this is effectively providing the investor with further market exposure. This strategy is effective where the investor believes the market has further upside potential. Positive sentiment post the national election and the formation of the Government of National Unity is an example of a macroeconomic event that led to a positive outcome for those investors with market exposure. Decreasing interest rates is another event. 

Where an investor is concerned about future rand weakness, they can enter into a currency derivative to protect their local share portfolio from possible future rand weakness against any offshore currency. Futures contracts referencing ZAR/USD can be used to protect a share portfolio against adverse ZAR weakness. 

What are the key considerations when making use of derivatives?

To enter into either a long or a short derivative contract the investor is required to place margin with the derivative provider. This margin is calculated as a percentage of the total exposure. Any adverse market movement will require the investor to place additional margin with the provider. As a result, investors need to be mindful of the cash flow requirements unique to derivatives. 

Conclusion

Derivatives can be an effective tool in providing a hedge against adverse market movements when considering your share portfolio. Investors who are keen to understand more should ensure they are well versed in the mechanics of these instruments. Remember that derivatives can provide short-term protection but it is key to have a long-term view when considering investing in shares, as this is the single asset class that delivers inflation-beating returns in the long run.