It can make sense to use derivatives as part of your investment strategy. But you must be careful to choose the right product to suit your risk profile and investment goals.
Derivatives can be more flexible than mainstream investments but they can also be more risky. So, while enhanced returns are great, you should also bear in mind the risk of enhanced losses.
Spread betting, contracts-for-difference (CFDs) or futures could leave you facing potentially unlimited losses, although you can reduce your risk level by setting stop-losses with your broker.
Using covered warrants or options means that your risk level is limited. You can also write options, which is a riskier strategy but which could be a clever way to make money in a flat or bearish market.
There are also hybrid products on the market, which combine features from different products. Binary betting offers a cross between the straightforwardness of spread betting with the tradeability of options, while listed CFDs are like a cross between CFDs and covered warrants.
Spread betting
Spread betting is perhaps the simplest form of derivative trading around and is certainly the most tax-efficient. Spread bets allow you to bet that the price of an underlying asset (a share, commodity or index) will rise or fall. This means that you could hedge your existing holdings, perhaps betting on a fall in the FTSE 100 to offset the risk of a fall in your UK portfolio.You could also use spread betting to speculate on your view of an underlying asset (a share price or index level, for example), either trying to profit from a falling price or hoping to make enhanced gains from a rising price. Betting on falling prices is known as 'going short', whereas betting on rising prices is called 'going long'.
See our introduction to spread betting.
Contracts for difference
Contracts for difference (CFD) work identically to spread betting but gains are not exempt from tax. On the plus side, CFDs are normally offered by stockbrokers rather than spread-betting firms, so you should be able to find tighter bid-offer spreads. Brokers normally offer CFDs based on the same spread as an underlying share and then charge a dealing commission on the CFD (both to open or close the position), whereas spread- betters normally widen the spread to make their profit.
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Covered warrants
Covered warrants are essentially options targeted at retail investors. They are traded on the London Stock Exchange, so all brokers will offer them, provided you sign a risk disclaimer. You cannot write covered warrants.
Like options, warrants have strike prices and expiry dates, so pricing can be a little difficult to work out. However, downside risk is limited to the premium paid, so they are suitable for either hedging or speculation. Again, buy calls to go long or puts to go short.
For more information on covered warrants, visit www.londonstockexchange.com.
Fixed-odds and binary bets:
For more on fixed-odds betting, see our weekly Fixed-odds wizard article.
Comparing short-term trading instruments:
The articles below compare the merits of spread bets, CFDs, options and warrants, and provide examples of trading strategies using each:
Futures
Futures have traditionally been used by institutions and professional investors and are traded on Euronext (www.euronext.com/derivatives). Many budget stockbrokers do not allow futures trading but you can use one of the UK's specialist brokers. Fixed contract sizes means that futures can be cumbersome, in terms of choosing the right amount of hedging to suit your underlying position (especially for small investors). They can also be expensive, as you need to pay for the future itself, as well as depositing a margin with your broker.
Options
Options have tended to be the domain of expert or institutional investors and can only be dealt through specialist brokers. They can be harder to value than CFDs, spread bets and futures. Whereas the latter three's returns are clearly based on movements in the underlying price, option prices do not move in such a clear way, making it harder to predict returns. On the other hand, options are only subject to limited risk (while allowing enhanced gains).
For more on how options and futures work, visit www.liffe.com/liffeinvestor.
