Derivatives - What are they?
Derivatives include futures, options (such as warrants) and contracts for difference (CFDs). They all have a few points in common in that you are buying shares with borrowed money, leading to what is called a geared position. They also give you the ability to short shares and make money when the stock is falling.
Gearing is the acceleration of a share’s move, so if a derivative has a gearing, say 6x, and the stock moves 10%, the derivative would move 60%. Great if you get it right, but horrid if you get it wrong. This is very important. It means that, while derivatives carry extra reward, they also carry extra risk and you should be very careful when trading derivatives.
Types of derivatives
Derivatives such as futures and CFDs can result in losses that exceed your initial cash outlay, because of the exposure. For example, if you buy a derivative with exposure of, say, R10 000, you may only be required to pay a R2 000 margin deposit. This means a gearing of 5x (the R10 000 divided by the R2 000 margin deposit). However, although you only put up a R2 000 margin deposit, your exposure is R10 000. If the stock loses R3 000 before you exit, you have lost the full R3 000, which is R1 000 more than your margin deposit.