After giving a rundown of the equities and fixed income methods of investing, we now look at the world of derivatives. Taking currencies as well as commodities as examples, we list the advantages and disadvantages of leveraging these vehicles as a method of investing.
As explained briefly in our introductory article, derivatives basically refer to any financial instrument whose value is derived from another financial instrument (also known as an underlying asset in this context) and then traded as a product in its own right. A key example of derivative trading comes in the form of futures markets, where one is able to buy and sell commodity and futures contracts for delivery on a specified date. The investor basically hedges or speculates on price movements of a specific underlying asset.
Maintaining its position as the world’s largest traded market – largely due to practical use for business as well as travel – foreign exchange (forex) is a highly liquid and often volatile arena. As the name would suggest, it involves the exchange of one currency for another or the conversion of one currency into another currency.
When it comes to currency derivatives, investments are most often made through forwards (contract between two parties to buy / sell underlying asset at a predetermined price at a later date), options (exchange of one currency for another at a predetermined price and date), and swaps (exchange of payment flows in two different currencies with each other on different dates).
One advantage of this form of investing is that it gives far more stability and predictability than traditional spot forex trading. Investors are able to protect their foreign exchange exposure but also hedge potential losses by taking necessary positions for the same. They are also able to leverage on margins, borrowing capital to maximise profits. Due to the transparent nature of currency trading, one can rest assured that insider trading does not exist.
Due to the fact that leveraging is involved, the downside is that investors can experience large losses if the wrong (speculative) financial decisions are made. They are also open to variables that are not in their control such as sudden sentiment shifts as well as governmental measures – which can cause large fluctuations in currencies.
Commodities investments typically involve buyers and sellers trading futures contracts for prices of metals, energy, livestock and meat as well as agriculture. Commodities exchanges do not set the prices of the traded commodities – prices are determined purely by supply and demand. To be considered a commodity, an item must satisfy three conditions: It must be standardised (for agricultural and industrial commodities it must be in a “raw” state), it must be usable (have a shelf life) and its price must vary enough to justify creating a market for the item.
Aside from being highly liquid, one of the draws of commodities trading lies in the fact that they operate on a margin, and investors are able to take a position at only a fraction of their value – standing to gain far more than they originally invested. The market also offers diversification to one’s portfolio as one commodity doesn’t always have correlations to another. Unlike the world of stocks and shares, prices often fluctuate independently. Due to the fact that they are largely controlled by governments, commodities are also rarely prone to rigging.
On the flip side, any contract that works on margins can backfire if managed poorly and one can lose much more than one invests. Most commodities are also prone to factors not in one’s control such as natural disasters, economic conditions, as well as overall supply and demand. Investors need to constantly gather information on the impact of global occurrences in order to invest in these markets effectively. An example of this is inflation, which can cause agriculture prices to rise due to factors such as increases in electricity costs and more.
As with any investment vehicle, it is imperative to seek sound professional advice before investing in any medium. That being said, the world of derivatives offers a viable diversification tool which, if timed right, can make up a highly profitable part of one’s portfolio.