Volatile and depressed equity markets have traditionally been a time when investors seek refuge in bonds and cash. A time to batten down the hatches, ride out the storm, focus on wealth preservation and forget about making money until markets recover their poise.
Endless possibilities
But, for the savvy investor, the arrival of a whole raft of retail derivative products means that this traditional view is outdated. Volatility and even falling markets can now be seen as opportunities to make money. This is primarily through the practice of short selling. Traditionally, this has meant borrowing shares to sell into the market in the expectation that the price will fall, then buying them back at the lower price. This has always been difficult for retail investors, but since Panmure Gordon's takeover of Durlacher, the one broker that allowed short selling, it is now all but impossible. But, as you will discover over the next few pages, short selling is very straightforward using derivatives. In fact, there is very little difference in practice between going long and going short. In the case of spread betting, for example, you are simply betting on whether a share price or an index moves up or down.
Reducing risk
But short selling is not just about taking advantage of volatility to make short term gains. By building short positions into your portfolio, you can reduce your overall levels of risk. For more risk averse investors in particular, this is a very attractive strategy. For example, you could buy BP through your stockbroker and then short the stock using a derivative, so that you are covered whether the share price moves up or down. This is precisely what hedge funds and, to a lesser extent, an increasing number of traditional unit trusts, do. So, by hedging your positions, you can actually reduce your overall exposure to the market. The more you hedge, the lower your exposure and, therefore, the lower the risk. You could, for example, simply short the market through one index derivative rather than short individual stocks.
Increasing profits
The other great advantage that derivatives offer is massively enhanced returns. This is because you only have to make a margin payment up front. For example, for spread betting and CFDs, this usually requires just 10-20 per cent of the overall cost of the contract, so you are getting the equivalent of £1,000 of equity exposure by investing just £100-£200. But while this clearly offers fantastic opportunities to make a lot of money, the opposite is also true. You need to be very careful using these two derivative products in particular, as you can lose a lot of money very quickly - although you can always use stop losses to limit your downside. And with options, covered warrants and binary bets, you never lose more than your initial investment.
Easy money
As you see, trading most derivatives is pretty straightforward. You can open an account with a provider quickly and easily, and can start trading for very modest sums. With most spread betters you can open an account with a couple of hundred pounds and start trading for as little as £1 a point. Most also provide virtual trading simulation so you can paper trade until you are confident enough to start risking your own money. But always remember, spread betting and CFDs may seem very straightforward in principle. But, beware: there are complications, particularly when it comes to charging structures, so you need to be absolutely sure that you understand these products well before you start trading. Indeed, CFD providers acknowledge as much and they insist that you demonstrate a certain degree of knowledge and experience before you can open an account. You will need to go to a specialist broker to trade futures and options. But covered warrants and listed CFDs are listed on the London Stock Exchange, so you can buy them exactly as you would a normal share.
This guide should give you a basic understanding of all the main retail derivative products available, as well as pointing you toward lots of useful sources of extra information. Derivatives open up a whole new world of trading opportunities, a world that all experienced private investors should be embracing.
