When most people think about investing, they picture stocks or bonds. However, there is a whole world of financial instruments that goes beyond these traditional choices. Derivatives are one such option. They offer new ways to manage risk, seek returns, and respond to changing market conditions.
In this article, Wealth Professional Canada will shed light on this type of investment as well as some derivatives rules. We will also look at five different types of derivatives plus other valuable insights.
Derivatives are financial instruments that get their value from an underlying asset. This asset can be any of these:
Instead of owning the asset itself, clients can use derivatives to speculate on price movements or hedge against risk. One can also gain exposure to different markets without buying the asset directly.
The value of a derivative changes as the price of the underlying asset changes. If you can correctly predict how the asset’s price will move, you might be able to profit from the derivative. However, derivatives are leveraged products. This means that they can magnify both gains and losses.
This might not be a derivatives rule, but derivatives are generally more suitable for experienced investors and financial advisors who understand the associated risks. Watch this video to learn more:
Derivatives can be traded on regulated exchanges or over the counter (OTC) through private agreements. Exchange-traded derivatives are standardized and regulated, while OTC derivatives are customized contracts between two parties.
Stocks represent ownership in a company. When your clients buy stocks, they become part-owners of the business. On the other hand, derivatives are contracts based on the price of an underlying asset. They do not grant ownership of the asset itself.
If you have clients who are interested in stock trading, check out this beginner-friendly guide on how to invest in stocks.
Derivatives serve a number of important purposes in investment strategies. Here are some of them:
In Canada, derivatives are traded on both organized exchanges and OTC markets. The Montréal Exchange (MX) is the main Canadian derivatives exchange. It offers trading in a wide range of derivative products, including options and futures on equities, indices, etc.
The MX is a subsidiary of the TMX Group, which also operates the Toronto Stock Exchange (TSX).
The Derivatives Act refers to provincial legislation that regulates the trading of derivatives in Quebec. Other provinces have derivatives rules under their securities acts and related regulations.
This law gives the Autorité des marchés financiers (AMF) the power to oversee, enforce, and make regulations for the derivatives market. The Derivatives Act also defines accredited counterparties, which include:
The purpose of this law is to make sure derivatives markets are “honest, fair, efficient, and transparent.” There are derivatives rules set in this legislation that aim to protect the public from unfair or fraudulent practices and market manipulation.
There are also derivatives rules set to help control systemic risk, especially through clearing and settlement of trades. This law even has rules for handling client complaints and protecting clients in matters related to derivatives trading.
Another derivatives rule is the requirement for fair process when handling complaints. If clients are not satisfied with how their complaint is handled, they can ask the AMF to review the case. Dealers must keep a register of complaints and report them to the regulator.
Penalties for breaking the rules can be severe. These range from fines to imprisonment for serious offences like fraud, misrepresentation, or market manipulation. The Act also gives the AMF the power to investigate and take action against those who do not comply.
Check out these five derivative types below:
A CFD is a derivative that allows traders to speculate on price movements of assets like stocks or currencies without owning them. CFDs allow profit from both rising and falling prices and use leverage to increase exposure, but this also increases risk.
Unlike shares, CFDs do not give ownership rights and have no fixed expiry date.
These are private agreements between two parties to buy or sell an asset at a set price on a future date. Forwards are not traded on exchanges and can be customized to fit specific needs. They are useful for managing risk but can be less liquid and carry more counterparty risk.
Futures are like forwards but are traded on exchanges. They are standardized and require the buyer to purchase (or the seller to deliver) the asset at a set price on a future date. Futures are often used for hedging or speculation.
These give the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset at a set price within a certain period. Options offer flexibility but come with the risk of losing the premium paid if the option is not exercised.
Swaps are contracts where two parties exchange financial obligations, such as interest payments or currencies. The most common types are interest rate swaps and currency swaps. Swaps are usually used by institutions to manage risk.
Watch this video for more information on these types of derivatives:
These types of derivatives offer various ways to speculate on financial markets for all age groups. For instance, one study reported an increase in derivatives trading among millennial and Gen Z investors.
Let’s look at a simple example involving futures contracts. Suppose your clients are involved in the coffee industry. They can use futures to protect against changes in coffee prices.
For instance, in the futures market, a coffee roaster might agree to buy a certain amount of coffee at a set price. This will be for delivery in the future. If the current price of coffee is $200, the roaster might lock in a price of $210 for six months.
Even though this is higher than today’s price, it protects against the risk of prices rising much higher in the future. The small margin paid is worth the stability it brings.
This kind of derivative transaction helps businesses plan for the future and offer stable prices to consumers. It also supports the economy by reducing uncertainty and volatility.
Derivative trading can be profitable, but it depends on the purpose. If your clients are using derivatives for arbitrage, the goal is to make a profit by exploiting small price differences in different markets.
If derivatives are used for hedging, the aim is not to make a profit but to protect against price changes or offset gains elsewhere. As a financial advisor, you need to help your clients realize that while derivatives can offer profit opportunities, they can also lead to losses.
This is especially true when used for speculation.
While derivatives are often used by large companies and financial institutions, they are also available to individual investors. However, because of their complexity and risk, they are best suited for those with experience and a solid grasp of the market.
Can derivatives help with risk management?
Yes, derivatives are widely used to manage risk. For example, a company can use futures contracts to lock in prices for raw materials or use swaps to manage interest payments.
Not every client will need or benefit from derivatives, but for some, these instruments can provide an extra layer of protection or open new opportunities. Just remember to always match the use of derivatives to your clients’ needs and risk tolerance.
You must also look at their long-term plans. Have open conversations about what they want to achieve and how comfortable they are with the risks involved. Take the time to explain how derivatives work in practical terms.
Use real examples that your clients can relate to. This can be locking in a price for a future purchase or protecting against sudden swings in the market. Encourage them to ask questions and share any concerns they might have. In the end, it’s about helping your clients feel positive and prepared, no matter what the market brings.
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