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Introduction to share investment

Equity Derivatives

Equity derivatives are securities that derive their value from the value of other underlying stock market instruments. The underlying instrument can range from shares, the gold price or indices. The most common types of equity derivatives are options, and futures. These products have limited lifespans and are settled in cash.

A futures contract gives you the right (and obligation) to buy or sell a particular financial instrument at a specific price on a future date. The quality and quantity of futures contracts that trade on an exchange are standardized and are transferable.

Other future contracts do not trade on the exchange but trade off the exchange on over the counter (OTC) markets. Such contracts are referred to as forward contracts or contracts for difference (CFD). These securities are not regulated by an exchange as their terms are agreed on between two parties.

On the hand, the option contract gives you the right but not the obligation, to buy (call option) or to sell (put option) a specific financial instrument (such as shares) at a specific price (strike price) on a specific date (delivery date).

Equity derivative contracts are used for:

  • Hedging- making an investment to reduce the risk of adverse price movements  in a security by taking an offsetting position in a related security such as a futures contract e.g. if you owned a share then sold a futures contract stating that you’ll sell your share at a set price, therefore avoid market fluctuations.
  • Arbitrage- benefiting from the same asset being valued differently by different exchanges or markets e.g. If a domestic share trades on an exchange in another country where it hasn’t yet adjusted for the constantly changing exchange rate. A trader purchases the share where it is undervalued and short sells it where it is overvalued, thus profiting from the difference.
  • Speculation-taking large risks by trying to predict future price movements of financial instruments.

To trade these financial instruments, you’d have to pay a good faith deposit (in cash) known as an initial margin. Profit and losses are calculated daily and then added, and deducted respectively from your account. Where the margin falls below a certain level, as specified in the contract, a trader may be asked to pay an additional cash amount, known as variation margin.

Equity derivative products trade on the JSE’s derivative market (formerly SAFEX) and a trader has to contact authorized users (members) of this market or from the website http://www.safex.co.za to trade in them. Futures and options are available on a wide variety of underlying instruments such as the Top 40 index, Krugerrands (gold coins) and the rand/dollar exchange rate.

Investing in derivatives is considered high risk and a trader should seek professional assistance before commencing trading.

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