Derivatives trading is very high risk, even for experienced investors.
Derivatives are complex financial instruments, and trading them is not a suitable ‘investment’ for most consumers. They are designed to track the value of something without the need to actually buy or sell that underlying thing and are used by professionals to manage risk or to speculate.
Fund managers might use derivatives to serve a specific purpose in their overall investment strategy, they are generally not suitable for retail investors due to their high risk and complexity.
Trading derivatives on the internet adds risk, since online scams related to derivatives trading are common.
A derivative is a contract whose value is based on an agreed-upon underlying financial asset (like a share in a company), rate (like an interest rate or exchange rate), index (like a share market index), or commodity (like gold or milk powder). Derivatives are used to either manage risk or to speculate.
Derivatives businesses mostly promote trading in derivatives where customers speculate on price movements in an underlying asset or rate. This is often with a focus on short term price or rate movements and high frequency trading.
Derivatives can also be used for non-speculative purposes such as when foreign currency derivatives are used to hedge currency risk on overseas investments or by importers and exporters.
Common types of derivatives include:
futures or forward contracts
contracts for difference (CFD), margin contracts, or rolling spot contracts.
Anyone who offers derivatives to retail investors in New Zealand must be licensed by the FMA and must follow disclosure and client funds rules.
Make sure that any provider of derivatives you deal with is licenced by the FMA. This is sometimes hard to figure out by looking at a provider’s website. If they are not upfront about it they probably aren’t licenced. If you deal with non-licenced providers you are missing out on important protections and may have no recourse if things go wrong.
You aren’t making an investment when you enter into a derivative, you are entering into a contract under which you will either pay or be paid money based the value or amount of something else. Any money you are required to deposit with the derivatives issuer is either the cost of an option or collateral to be held to cover your possible future losses – you are not “investing” that amount.
If you are on the winning side of a trade, the money you get paid will come from whoever has lost money on the other side. When you are on the losing side of a trade, you’ll pay the other party.
Understanding the risks
When entering into derivatives you need to understand not only the market risk in relation to the price or amount of the thing the derivative relates to, but also the risks and features of the derivative and the credit worthiness of your counterparty.
Derivatives can relate to virtually anything. If a derivative relates to something that is traded in an unregulated market or something that is not independently verifiable, there are additional risks in relation to the potential manipulation of the value of the underlying reference price or rate.
Fees and charges may also be difficult to understand.
Some general risks particularly affect derivatives products:
Are the counterparties creditworthy and trustworthy?
The issuer itself will be a counterparty. The PDS will also have a list of other counterparties. Check to see if the counterparty is in New Zealand or overseas.
You may only deposit a portion of the value of the underlying asset upfront, but if you lose you will need to pay the full amount of the change in value of the underlying asset. Some Contracts for Difference (CFDs) have a leverage of 1 to 100, meaning that for an initial margin of $1,000 you will be exposed to $100,000 value of an underlying asset. This means a 1% adverse move in the price of the underlying asset would wipe out your margin.
Many derivative contracts are not traded on an open market, so they can be harder to trade and harder to value. Liquidity risk applies if you want to close your position before the contract matures. In times of market stress you rely on your counterparty to provide you with access to their trading platform and a reasonable price to exit.
You may pay fees every time you enter into a derivative (similar to the brokerage fees paid when shares are traded). There may also be holding costs. Some contracts may also include hidden costs.
What to do before you invest
Be cautious of companies who say they can quickly teach you how to trade derivatives. Derivatives are complex and you can easily lose more than you have to pay upfront. When banks and fund managers trade in derivatives, decisions are made by specialist staff to fulfil a specific purpose as part of a wider risk management or investment strategy.
If you are considering using derivatives in your portfolio, take the time to understand how they work. You will be asked to read the product’s disclosure statement (PDS) and sign a client agreement which spells out processes like how the product will be closed out.
Are the counterparties creditworthy and trustworthy?
The issuer itself will be a counterparty. The PDS will also have a list of other counterparties.
Do I understand how this type of derivative works?
Make sure you understand how the derivative is structured, how you will make money and how you will get paid and what the product’s costs and fees are. Even when a PDS meets regulations, the product can be difficult to understand. We strongly recommend you seek advice.
What will my contractual obligations be?
Contracts are legally binding, no matter what the market value of the asset is when the contract matures. This means either the buyer or the seller can face high losses.
Can I afford to lose money?
Derivat¬ives are high risk – your losses (or gains) can be many multiples of the amount you might initially need to pay. Also, the issuer may have the ability to automatically close all of your positions without getting your approval first.
Managing your investment
Managing derivatives may require close attention and a significant time commitment. You will need to ensure you understand all the details of the product and any obligations you will have throughout the duration of the contract. There are no reporting requirements from the derivatives issuers.
Depending on the type of product, you may need to keep track of the value of the derivative’s underlying asset, and/or take action as a result of market movement. This could include having to deposit more money to maintain your position.