A derivative is a contract between two parties to conclude a transaction today, but only settle in the future. Derivatives are also called futures or options contracts. There are different types of options, and We will explain options as a separate topic. The most popular derivatives are futures contracts like contracts for difference, index, currency, and single-stock futures. 

Derivative contracts can be used to mitigate risk (hedging) or assume risk (speculating on the direction of price movement).

Counterparty performance on derivative contracts is secured through a system called margining. Each party to the contract deposits money as a “good faith deposit”. Daily price movements result variation cash flow based on movements of the underlying. Cash on a derivative contract is adjusted daily. Initial margin must be maintained at all times.

Market movements against the direction of the position would require further cash deposit to maintain the position. This is called a margin call. Profits and losses are transferred between parties to the contract through variation margin. Market movements in the direction of the position (up when long and down when short) result in cash flow to the account. The position is marked-to-market (compared to movement in the underlying) and cash movements are recorded against the accounts of both positions. The effect is either a daily profit or loss. Settlement only takes place in the future (hence a futures contract) but profits and losses are recorded through daily cash-flows. 

Let us look at an example:
Trader A believes Share Z has potential to go higher despite the recent upward run. Trader B thinks the stock is expensive and desires to hedge the equity position held in the stock. They do not want to sell the actual stock but are expecting a strong pullback in the share price. 

Trader A buys a Single stock futures contract that gives him exposure to 100 x Z shares. He deposits 15% of the value of 100 Z shares as margin. Traders B sells 1 contract of the SSF in share Z. He also deposits 15% of the value of 100 Z shares as initial margin. Let’s assume the price per share is R 100. The exposure would be R 10 000 (R100 x 100 shares) and margin would be R 1500 (15% of exposure). The effective gearing would be 6.7 times (100/15). Gearing amplifies the price movement. 

Now let us assume the price of share Z rises by R 1 (one Rand) the next day. Trader A will receive R 100 in cash into his account through marked-to-market system. Trader B is required to deposit a further R 100 (R1 x 100) in variation margin to maintain the position as his MTM position would be negative R 100. The next day sees an extremely negative news report about the future operations of share Z’s business, and the share tanks – down R 20.
Trader A has an extra R 100 from the previous day’s positive movement, but he must now furnish R 2 000 in variation margin. This variation margin will be transferred to the opposite position holder trader B (who sold the contract). Trader A has to pay in R 1900 which is more than his initial margin requirement to enter the contract. Trader A’s loss is thus more than 100% of his capital outlay. He only paid R 1 500 to gain exposure in R 10 000 worth of shares. This illustrates the effect and dangers of gearing. If Trader B only bet on the price dropping without holding any of the actual underlying shares, he would have also had a naked position (like trader A). Naked positions in derivatives are highly speculative in nature and not suited to everyone. 

A hedge would be implemented where trader B owned 100 of the actual Z shares and went short the futures contract. As the price dropped, he would have gained cash on the futures contract. The value of his underlying shares dropped by the same amount. He is thus hedged against price movement at a locked-in price. He would not have been affected by the move. He made profit on the futures position (cash movements) but he lost on the value of the underlying shares.  

If the share price continued to rise, he would lose on the derivative contract but would make the gain on the underlying share. Trader B is locked into a valuation price of R 100 per share regardless of where the share price goes. This example does not account for costs but only attempts to explain the principle of a derivative and one of the uses thereof.
If you need more information about derivatives and their uses, call one of our investment specialists on 0860 000 368 or mail us at wealth @psg.co.za.