What are Derivatives And How to Invest in them in South Africa

What are derivatives (deriv) and how to invest in deriv in South Africa? Forward, futures, options and swaps are derivatives. In this deriv guide, you will learn about the most common types of derivatives and how to use them to protect yourself or to profit in South Africa.

Have you heard of futures contracts? And options or swaps? All of these names are types of derivatives, a financial instrument widely used by investors to protect their operations – or to profit from the market.

As it allows the movement of small amounts, the derivatives market has aroused the curiosity and the increasing interest of individuals.

But how effectively do these instruments work? How can they be used to compose different application strategies?
That’s what this deriv South Africa guide will answer. Check out:

• What are derivatives?
• Reasons to use derivatives
• Types of derivatives
• How to invest in the derivatives market

What are derivatives?

The name already indicates: derivatives are a financial instrument that has the price “derived” from the price of an asset, a reference rate or even a market index.

There are derivatives of physical assets, such as soy, coffee or other, but also financial assets, such as stocks, interest rates or currencies.

Whoever trades a dollar futures contract, for example, does not operate the dollar itself, but a contract based on its value in the spot market.

There are four most common types of derivatives:

• Forward contracts
• Future contracts
• options
• Swaps

Negotiations can be carried out both on the over-the-counter market and on exchanges. In South Africa, Deriv.com has a highly developed derivatives market.

Not always, but generally, derivatives are established as standardized contracts. This means that its characteristics and the specifications of its reference assets – such as quantities, terms and pricing methods – are defined in advance.

Thus, everyone who buys an option on a stock for a certain maturity at Deriv.com, for example, will purchase the same product, under the same conditions.

The traditional dynamics of derivative trading is simple. The trader undertakes to buy or sell a particular asset for a specified price within an established period.

When buying a corn futures contract at Deriv.com, for example, the investor is negotiating the equivalent of 450 bags of 60 kg of the product, at the market price, with validity until expiration – the contract may have the expiration established for some years to come. days, months or even more than a year.

With regard to settlement, in the derivatives market it can occur in two ways. When settlement is physical , it is necessary to deliver the asset under negotiation on the due date. It is more common in the agricultural market – and even in this segment, investors are often not interested in soy, corn or coffee itself. If your objective, in fact, is to win with the negotiation of securities, physical settlement is not necessary.

The other form of settlement is financial , which is made by difference. In this case, on the day the derivative matures, a sale to the original buyer and a purchase to the original seller are recorded. Only the difference between the values ​​on each side of the transaction is moved, which is concluded without the need to deliver the negotiated assets.

Reasons for using derivatives

What is a derivative for? The pure and simple description of what an option or a futures contract is often does not give investors the dimension of the type of use that the market makes of them. In practice, in general, derivatives are used to:

Protection

A derivative can be used to protect the value of an asset – a stock or a commodity, for example – from changes that may happen in the future. This is because it allows to fix in advance the value of a commodity or a financial asset, which helps to lessen the impact of an eventual change in market prices.

The classic example is South African companies that have debts in dollars. Imagine that, at a certain moment, the currency price goes up. In this situation, companies need to spend more to pay off debts, because they are more expensive.

To avoid this type of effect, many companies choose to buy dollar futures contracts – where the currency price is predetermined for a future date. Thus, even if the price goes up, they have already acquired the right to trade the currency for a certain amount, which provides predictability for the cost of their debts.

Another example of using derivatives for protection is that of farmers who produce agricultural commodities, or mining companies that work with metallic commodities. With futures contracts, they can guarantee – or “lock”, as they say in the market – the price of sales of goods and avoiding losses due to a possible drop in prices.

A term used to refer to the protection provided by derivatives is hedging . Hedges are less concerned with profiting from operations and more interested in avoiding losses.

Speculation

Unlike the hedger, who seeks protection for operations he has in the real economy, the speculator buys and sells derivatives to profit. He wins with the small price differentials for the purchase and sale of each contract.

For a speculator, it doesn’t matter much whether the derivative traded is currency, an agricultural commodity or interest rate, because his interest is not in the underlying assets.

Many speculators operate in the day-trade , which means that they make purchases and sales of the same derivatives over the same day – and calculate their gains (or losses) at the end of the trading day, accounting for the difference between the prices at each end of the operations. Others, hold open positions for a few days, betting that in that period prices will rise or fall (and profiting from these results).

Arbitration

Some investors use derivatives to make arbitrage transactions. It means that they seek to profit from the price discrepancies they find for the same product in different markets. For this reason, in addition to derivatives, arbitrage operations may involve other assets – such as stocks on the spot market , for example.

This is possible because the pricing process is not perfect. Although the assets are exposed to the same economic circumstances and, because of this, the expectation is that they fluctuate to the same extent, this is not always the case. It is in these moments that an opportunity for gain may arise.

A stock option, for example, may indicate a future price for the paper that is different from what the spot market investors project. When they see this, the arbitrators act, and quickly, before the market adjusts prices. As soon as they profit.

In general, the risk taken by the arbitrators is considered to be low. Since the basic strategy is to buy the asset or derivative in the market where the price is lowest and sell in the market where it is highest, the acquisition and sale value is already known in advance – and this makes the operation more accurate.

In arbitration, the profit from each transaction is usually small. Therefore, the gains effectively come from the quantity and volume of purchases and sales. The more voluminous and frequent the businesses are, the greater the chances of accumulating bigger gains.

Derivative types

Know a little more about the types of derivatives and the peculiarities of each model of contract;

Forward contracts

Whoever buys a forward contract commits to buy a commodity or a financial asset, in a determined quantity, for a price that is established from the moment of negotiation, for settlement on a date in the future (also defined from the beginning). For those who sell a forward contract, the commitment is the opposite: to sell that same asset. These instruments can be traded on the stock exchange, but also on the over-the-counter market.

Future contracts

The definition of a future contract is very similar to that of a forward contract: it represents the commitment to buy or sell an asset for a certain price at a date in the future. The main difference is in the settlement format.

In the case of forward contracts, the settlement of the transaction occurs only on the maturity date of the paper. In the case of futures contracts, there is a so-called daily adjustment. Because of this mechanism, all futures contracts that investors hold are valued daily from a reference price, called the daily adjustment price. Thus, in practice, operations are adjusted every day according to market expectations for the future price of the contract’s reference asset.

The daily settlement price takes into account the average price of transactions made with the paper on the futures market in the afternoon. The difference – positive or negative – between the daily adjustment prices from one trading session to the next is determined. And the investor who has open positions must pay this difference (if it is negative), or else he will receive the amount in his account (if it is positive).

The daily adjustment, therefore, is a system that determines losses and gains and that helps to increase the protection of positions in the market of futures contracts. Another difference between them and forward contracts is the fact that they are only traded on Exchanges.

options

The options are the right to buy or sell an asset at a fixed price at a future date. To buy an option, you have to pay an amount to whoever sold it – called a premium. It is not the price of the asset itself, but an amount paid to be able to buy or sell the asset later.

In the South African market, the best known are stock options – but there may be options of other types as well. What is in common is that these reference assets are traded transparently on the floor.

Anyone who buys an option is called a holder. He always has the right to exercise the option – that is, to buy or sell the asset on the due date at the price agreed from the beginning. However, you are not required to do this. You can simply choose to let the option win, with no major consequences other than losing the amount you paid as a premium for it.

The seller of an option, also called a launcher, always has an obligation to exercise if the buyer wishes to do so. Think about Petrobras stock options, for example. If, on the maturity date, the holder wants to exercise his right to buy Petrobras shares at the agreed price, the launcher is obliged to arrange the corresponding papers to sell to him.

Swaps

A swap contract is an agreement in which two investors negotiate the exchange of profitability between two assets. In practice, they exchange cash flows with each other, taking as a starting point the profitability of one of the assets compared to that of the other. The objective is to reduce risks and increase predictability for those involved in the operation.

Think of a gold swap contract against JSE, the main stock index in the South African market. If, on the expiration date of the contract, gold has a value below the JSE variation, whoever bought JSE and sold gold will receive the difference in profitability. If the return on gold is higher than the JSE variation, the difference is won by those who bought gold and sold JSE.

How to invest in the derivatives market in South Africa

Are you interested in trading derivatives in the market? Follow some steps to make successful trades with these financial instruments:

Know your investor profile

Before making any investment decision, it is necessary to ask yourself about the investor profile itself. Imagine different market, profit and loss scenarios, and try to identify your most likely reaction to each one. Would you be able to withstand some loss over a period of time? Or does this possibility cause excess distress and tension?

Also assess how much you could dedicate yourself to the derivatives market. As they involve a level of complexity above that of other equity instruments, such as equities, derivatives usually require closer monitoring of operations and more time to study strategies and the best deals. Are you willing to do that? If so, go ahead with conviction.

Choose a broker to trade

Trading derivatives requires having an account with a securities broker. These institutions perform the intermediation of operations on the Deriv.com floor. For the specific case of this market, it is worth considering some aspects in particular.

First, check the trading fees charged by the brokerage firms you are evaluating. It is common for transactions with derivatives to be of low but very frequent values ​​- and thus, a high rate can end up eating away at the gains.

Then, also evaluate the analysis and trading systems made available by the broker at your home broker . Are they easy to use? Do you allow in-depth analysis to be carried out in a simple way? It is important to find the ones that are best suited to your needs.

Brokers can also make specific requirements for those who trade certain types of derivatives, such as margin deposits. Check the conditions that they establish for these services.

In order to open an account with a broker, it is usually necessary to send copies of some documents and complete certain records – but this is usually a relatively simple procedure. Once the account is active, just transfer funds to the broker (through DOC or TED) and start trading.

Analyze derivatives and define a strategy

Before starting to operate, you will need to define your investment strategy. Are you interested in derivatives as hedging instruments for some other investment position? Or do you seek to win as an arbitrator or speculator, with small price changes in the short term? Being aware of this is essential to choose how you will position yourself in this market.

When this is clear, seek to make or read analyzes on the derivatives that interest you. Brokers and analysis houses usually provide reports indicating options for different operations with derivatives, guiding investors regarding their advantages and disadvantages. Be sure to look for this type of document before starting your own negotiations.