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Derivatives: the basics

Created:
27 May 2005

All the derivatives featured in this Masterclass have three things in common:

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  • you can use them to speculate on rising or falling shares
  • you can avoid paying stamp duty
  • you get increased leverage (greater exposure to the potential upside and downside than with buying and holding a share).

Our downloadable table (a PDF file) summarises the main differences between the three main retail derivatives. But first, here is a summary of how they work.

Spread betting

This is financial betting at its most basic. The spread-better acts as the bookie. You bet that a share will go up or down. If you are right, you win. If you are wrong, you pay the spread-betting company. A share with a mid-price of 500p might be quoted at 498p-502p. If you bet the share will go up, your bet starts at 502p. If you bet it will fall, your bet starts at 498p. In both cases, the share price has to move through the spread before you make any profit.

You can bet from as little as £1 per point, where a point is equivalent to 1p in the share price. For that reason, a £1-per-point bet on drug company AstraZeneca is riskier than the same bet on media agency Aegis. Why? Because AstraZeneca's share price is around 2,150p. It often zips up or down by 50p (or 50 points) in a trading session. Aegis's shares cost around 100p and seldom move more than 5p (or 5 points) a day.

If you bet on Aegis rising at £10 per point, with a stop-loss 10 points lower, then your maximum loss (and your initial stake) could be £100. If Aegis rises from 100p to 105p, you will have made £50 - or £40, taking into account a 0.5p spread either way. That's a 40 per cent return on your £100 on the back of a 5 per cent rise in the underlying share.

Contracts for difference (CFDs)

A CFD is an agreement between you and a broker to pay the difference between a share price when you open a contract and its price when you decide to close it. The effect is the same as a spread-bet: you make money if your investment hunch is correct and pay out if you are wrong.

Most CFD providers will quote you the market price, without the extra spread applied on either end that many spread-betters charge. However, CFD customers normally pay 0.2 per cent commission.

Both CFDs and spread-bets are designed for short-term trading. So, if you maintain your long exposure to a share overnight, you begin to pay a financing charge (after all, you are effectively borrowing someone's money to invest - that's how it is possible to generate 40 per cent returns from 5 per cent returns in the underlying shares).

Covered warrants

Covered warrants are simplified options. They come in two basic varieties: call warrants if you are bullish about the underlying, and put warrants if you are bearish.

If you buy a Vodafone December call warrant for 150p you have the right, but not the obligation, to buy Vodafone for that price in seven months' time. If by then Vodafone has soared to 180p, your warrant would be worth 30p. If Vodafone is beneath the strike price of 150p, the warrant will expire worthless.

This warrant will be worth more if it is 'in-the-money' - in this case at or above 150p - than if it is 'out-of-the-money'. If Vodafone becomes more volatile, the warrant will rise because there is a greater chance that it will rise above the 150p strike price.

There are two elements to a warrant's value: intrinsic value (how far it is in the money) and time value (the value of having an option to buy Vodafone). That's because having the option but not the obligation to buy an asset is always worth something, although that value erodes rapidly, the closer it comes to expiring.

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