Derivatives

Derivatives
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Although equities are a very tempting investment and can provide an attractive return over the longer term, an active investor wishing to profit over the short term, especially when share prices are either particularly volatile or tending to fall, will find life very difficult. This is because it is not possible to “go short” that is, to sell a share you do not own with the intention of buying it back later when prices are lower, for a profit. Shares themselves are a “long only” investment - if you do not own them, you can only buy them.

However, there are certain financial instruments based upon equities, such as options and futures, which do make it possible to benefit from falling share prices. These are called derivatives (as they are usually derived from underlying equity or other security) and also include such instruments as warrants, contracts for difference and even spread betting. Indeed, the list is virtually endless as the likes of the investment banks can construct new derivatives almost at will to fill a particular gap in the market.

Such derivatives can usually be purchased for a fraction of the cost of a position in the underlying equity itself, that is, they are highly geared. They are therefore liable to be much more volatile than the underlying equity upon which they are based, with a correspondingly higher potential loss. Used alone, derivatives perhaps have more in common with gambling than investment. However, in combination with a portfolio of the underlying shares upon which they are based, derivatives can be used to reduce risk.

Although private investors are well advised to leave derivatives alone unless they themselves have a particular expertise, professional investors are well used to dealing with such financial instruments. A private client portfolio, investing directly in equities, and managed by a firm of stockbrokers or similar, is unlikely to include derivatives but a professional fund manager running a unit trust or OEIC (Open Ended Investment Company) may well use them to some extent.

However, most managers of most retail collective funds will not use derivative instruments to a very great exten, often as a result of regulatory restrictions. Whether their fund grows under their management will be largely a function of the capital appreciation secured by the indiviudal investments they hold within their fund. A private investor looking to profit from shares when prices are falling must go elsewhere.

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