MM’s 5 minute guide to Derivatives

16th August 2010

Call options

What are they?

An option gives the owner the right, but not the obligation, to buy or sell an asset at a specified price at a specified point in the future. These can either be call options – which give the option to buy something – or put options – which give the option to sell something.

How are they used by fund managers?

These tend to be used by income managers to boost the yield on a portfolio. Managers will sell the option to buy stocks within their portfolio at a certain price in exchange for an upfront payment. For example, they may sell the right to buy Capita Group at 708p for £1,000. If the shares went down to 680p, the option would not be exercised and the fund manager would simply keep the £1,000. If the shares went up to £8.10, the option would be exercised and the fund manager would have to sell the shares and miss out on the rise in the share price.

What are the risks?

The ‘covered' bit is important. If a fund manager sells an ‘uncovered' call option, he runs the risk that he will have to buy the shares at the higher price to deliver to the buyer. In practice, very few fund managers will risk selling options on shares they do not already own. For covered call options, the loss is limited to the potential upside in the shares that has been given up over and above the premium received for the options.

Futures

What are they?

Futures contracts are an agreement to buy or sell a specific asset at a specific price at a specific point in the future. Futures can be created on almost any asset, including individual shares, indices, currencies and bonds. The price of the future will vary with the price of the underlying asset, the time to expiry and market volatility.

When are they used?

Fund managers will often use futures when they want to protect overall returns, but do not want to sell out of their underlying holdings. For example, if they predict that there will be lots of short-term volatility in the market, they may be a three-month index future allowing them to buy the FTSE 100 at, say, 4,200. If markets fall, the profit they make on the future will shore up overall portfolio returns without having to make costly adjustments to the underlying holdings in their portfolio.

What are the risks?

Again, the risks in buying futures are largely when there a fund manager has an ‘uncovered' position. In the above example, if markets went up to, say 4,600, the manager may lose money on the future, but the gains in his underlying portfolio should protect him.

Contracts for difference

What are they?

A CFD creates a contract between two parties speculating on the movement in an asset price. The assets on which CFDs are available include shares, currencies or indices. The final payment will reflect the movement in the price of the asset between the opening and closing of the contract. If the asset rises in price, the buyer receives cash from the seller and vice versa. CFDs are relatively simple instruments and the price will simply mirror that of the asset in the underlying market.

When are they used?

CFDs are used in absolute return funds to enable managers to profit from falling markets. Fund managers can use them to effectively ‘short' stocks, i.e. profit from falls in a share price.

What are the risks?

Investors only have to pay margin upfront, which means that they can access a large amount of shares for a smaller sum than they might otherwise be able to do. This leverage creates risk and investors can incur very large losses if the position moves against them. The majority of fund managers, therefore, employ stop-losses and value at risk measures. Stop losses force managers to sell out if they are at risk of losing, say, 10% on a holding. ‘Value at risk' looks at overall portfolio returns and judges risk based on that.

Further reading:

Moneyweek's 'Beginner's guide…' is a great place to find out more

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