There was a time when shorting shares was as complicated as you could get on the stock market. Nowadays, the financial whizzes have come up with many different ways that you can trade on the price of, well, virtually anything. Many of these fall under the heading of derivatives. The term covers many different sorts of trading, including some which have been blamed in part for the global financial crisis. The idea is an easy one, but sometimes greed has made the financial experts take leave of their senses, it might seem.
Simply put, derivatives are financial instruments that “derive” their value from something else. Many of them have the principle that you can gain much more than you risk – this is really the point of the derivative. For example, spread betting which is so popular in the UK is a financial instrument which derives its value from the price of something else. If you spread bet on a stock, there is no chance you’ll ever own the stock but you will make or lose money by the way the stock price changes. For a relatively small initial stake, you open yourself to the opportunity of substantial gains.
Before spread betting became so popular, contracts for difference (CFDs) was the financial derivative of choice for doing a similar thing. As the name suggests, you gain or lose based on the difference in price of a stock over time. Once again, you don’t have the complication or cost of actually dealing in the stock.
Apart from the principle of gearing up the effectiveness of your money, sometimes called leverage, you can get other advantages from using derivatives. For instance, as in the types of trading referenced above you are not dealing in the shares themselves you will never have to pay stamp duty to the Treasury. Another advantage which is quite possibly more important, at least the way the tax laws are at present, is that spread betting is, as the name implies, regarded as betting. This means that any winnings are betting winnings, and therefore not subject to capital gains tax.
This principle does not apply in the same way around the world. For instance in the US all betting winnings are taxed, as are lottery winnings in a similar fashion. If you also lose at gambling, you can keep a record of your losses, and offset them against any gains you make when you come to do your taxes. This may seem of little significance if you win millions in the lottery and have to pay half of it back to the government, but for the addicted gambler it provides some relief. But the fact that betting is taxed is one of the reasons that the demand for spread betting in the US has not been great, and as yet regulations do not permit it.
Once you have the principle of profit and loss based on the price of a separate item established, then you can expand it to cover many different fields, the only requirement being that the betting is on varying prices that cannot be fully predicted. Thus in the UK you can spread bet on house prices, currency fluctuations, bond markets, and on futures and options, which themselves are derivatives, as well as on the international stock markets. You’re not limited to betting only on shares that are available in your country – provided there is a published price, a spread betting provider can take your wager.
When you apply gearing to the markets, it generally increases how much you risk losing as well as how much you can gain, so derivatives come with a real warning of being hazardous to your wealth. You can lose more than you originally staked, and more than is in your account. There are laws and safeguards to try and protect you from harming others, if you have acted in a way that loses a lot of money, but these rules will not save you from Personal Disaster.
Your broker or dealer is entitled to safeguard his own best interest, terminating your trade, asking you for more money, or whatever is necessary to try and make sure he does not lose. You should never rely on this to close a losing trade for you, as ultimately any losses you suffer are your responsibility, and you can be sued in court for recompense. That said, the flip side of this gearing is the major appeal of derivatives. You have the chance of gaining much more than by simply buying and selling stocks.
A significant example of derivative risk was embodied in the Credit Default Swaps (CDS) which were invented to trade around the risk of anyone defaulting on a loan. In the US, bunches of mortgages were grouped together by financial experts and traded on the markets. In effect, the derivatives that they invented (CDS) were providing insurance against the debts going bad, but they got traded significantly in a speculative manner. The principle was that you paid a premium, and in return if the debt was unpaid, you would get recompensed by the person receiving a premium.
One problem with this was that you did not even have to have an interest in the debt; you could still pay the premium and collect on default. Some people have said that this was similar to taking out fire insurance on your neighbour’s house – if enough people speculate on this, and the house catches fire, there is a major undeserved and unwarranted payout, not to mention suspicion all round. The consequences of this reverberated around the economic crisis of 2008 – Lehman Brothers and AIG suffered because of it.
In the next section, Commodities, we cover some other derivatives known as futures contracts. These again have been known to yield fortunes to those who have the insight and information to trade them in the right way. However, you do not need to trade futures directly, and have to work with their standard trading sizes, as you can also use spread betting to bet on the change in price of the futures contracts. It is simply a derivative of a derivative. This has the advantage that you can choose exactly how much to stake, and of course have tax advantages in the UK on any winnings.