Derivatives

Derivatives
Today my topic is investing in derivative Exchange Traded Funds (ETFs) and other information about derivatives. What is a derivative? It is a security, the price of which is related to one or more underlying assets. An example of the underlying assets can be commodities (i.e. Gold, Natural Gas or Oil), currencies (i.e. US or foreign), options, stocks, bonds, stock indexes, etc. It is a contract between two or more parties. Its price fluctuates with the price of the underlying asset and some derivatives can be highly leveraged. The most common types of derivative are future and forward contracts, options, swaps and stock indexes. Underlying other derivatives are such things as weather, amount of rain, number of sunny days, etc. Virtually anything that bears risk in one direction or the other can be a type of derivative.

Why and how are derivatives used for hedging against risk and investing? They can be used to hedge risk, speculate, maximize profit whatever direction the market or assets go and to help manage portfolios. The following is an example of how derivatives can hedge risk for sellers and buyers. A farmer who plants wheat wants to reduce his risk of losing money and the possibility of losing his farm if the price of wheat is low at the end of the growing season. At the beginning of the planting season he sells his future wheat via a derivative contract to a manufacturer that uses wheat as a raw material. The farmer knows what he will be paid at the end of the growing season for a bushel of wheat and the manufacturer knows what the cost of his raw material will be. This reduces the risk of both the farmer and the manufacturer. This is one of the reasons why derivatives have become so popular: they enable risks to be traded efficiently. If you review the 10K reports of major corporations you will see that many of them use derivatives to hedge against risk. For example, corporations that sell goods worldwide will use currencies derivatives to hedge against currencies risk. Natural Gas (NG) drilling corporations sometimes use future contracts to hedge against risk for some of their production. They at times use future contracts to know what price they will get for NG over the next year, thus improving their ability to plan and reducing risk to the corporation.

You can also use derivatives for investing by using ‘exotic’ or ‘simple’ ETFs. Exotic ETFs use, for example, interest rate swaps and forward one month future contracts. A simple ETF might use the Standard and Poor’s (S&P) 500 index. An example of an exotic ETF is the following: in the summer of 2008 you determined that the financial sector was going to have a major drop in stock prices. You could have used an inverse (also known as ‘bear’ or ‘short’) derivative to play this opportunity. Inverse derivative ETFs could have been used for this investment (you could have shorted the financial sector 2 or 3 times). If you think the oil sector is going to increase its profits and that oil corporation share prices will increase you could use an Oil stock index ETF (simple) or leveraged ETF (exotic) to take advantage of the increasing share prices. You can maximize your profit whatever direction the market is going by using derivative ETFs.

If you are going to use exotic ETFs you should have a very good understanding of the underlying assets and the advantages and disadvantages of using these financial products. You may want to ‘Google’ exotic ETFs and read up on their associated pros and cons. For example, the US government looks at the underlying assets to determine tax rates. Some exotic ETFs can be taxed at ordinary gains and not long term gains if the asset is held over one year (you could use these ETFs in your deferred tax account). The Commodity Future Trading Commission is reviewing whether it should put limits on energy future trading ETFs using one month forward contracts. Examples of these ETFs are OIL (tracks Oil) and UNG (tracks Natural Gas).

Derivative ETFs can also help you manage your portfolio to maximize your profit and tax liability. For example you buy a financial corporation stock that pays a high dividend that you think is a very good long term investment. You have only held the stock for three months and the market for financial stocks looks like it is going to decline. You don’t want to sell the stock because of the high dividend, tax implication (it would be a short term gain) and you like the stock. You could use an inverse leverage derivative financial sector index ETF to hedge your risk with the stock.

Please do your homework (as you should do on any investment) before buying derivative ETFs. You should always understand the underlying assets of the derivative, tax implications, advantages and disadvantages, selling strategies (i.e. stop orders) etc.

Next week, I will write about bonds. Future topics may include:

- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Other topics

In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks and Mr. C (need to talk with him).

Please add your insight. I would like to have an on-going discussion of financial and investing ideas.

Paul