Derivatives and other tradable products

For every beginning investor the amount of tradable products on the market can be overwhelming. There are mutual funds, ETFs, turbo longs, turbo shorts, options and much more. Without an overview, it’s difficult to make the right choices between these products when making a portfolio. This article will treat the most commonly traded products in alphabetical order. These products all have one or more of the five main investment categories as underlying asset value.

Some products can be highly complex in nature. This article will only scratch the surface for most. For more in-depth information on all products I can recommend Investopedia.com.

For every product, these questions will be answered:

A summary of all products can be found at the end of the article.

Contracts for Difference (CFDs)

CFDs are contracts between two parties, often a person and a broker. CFDs always have a value based on an underlying asset in the form of stocks, indexes or raw materials. When selling a CFD, the difference between the price at purchase and the price at selling is payed to the one who predicted right. CFDs allow people with relatively small budgets to play on the open market, without having to buy stocks or bonds directly, which can be quite expensive investments. With CFDs people can go long (when expecting the underlying asset value to rise) or go short (expecting the underlying asset value to fall).

The risks with CFDs are high. CFDs have an added leverage effect which ensures large profits can be gained with a minimal budget, but the losses can also be large. If the leverage ratio of a certain CFD is 10, it means the CFD will gain 10% in value if the value of the underlying asset gains 1%. The same is true for decreasing values. In short, the leverage effect makes values of CFDs rise or fall stronger than the value of the underlying asset. The leverage effect will be explained in more detail in a future article. With CFDs it’s easily possible to lose your entire budget in just a few minutes. These risks make CFDs by definition highly speculative in nature.

Exchange Traded Funds (ETFs) and trackers

ETFs or trackers are unmanaged funds which hold multiple assets. Most ETFs track an entire index, making these assets perfect for any investor wanting to diversify their portfolio with minimal costs. Because ETFs are largely unmanaged, periodic costs are low when compared to managed funds (see below). ETFs exhibit the same features as stocks. Investors will normally receive dividend as well.

The risks of investing are low when sticking to “normal” stock or bond ETFs. Because diversification is easy with ETFs, these assets are perfect in the defensive part of an investment portfolio. ETFs are not speculative in nature.

Futures

A future is a contract to trade some underlying asset in the future with a fixed value from today. Futures can have underlying assets like gold, dollars and indexes. Due to the added leverage effect there is a high risk of losing money fast. This makes futures speculative in nature.

Futures are not useful for any investor with a long term goal because most futures have a short duration. Another added (and probably unwanted) feature of futures is that sometimes the settlement is not in cash, but with physical items. This is especially true for futures from raw materials. It could mean you end up with a few barrels of oil on your doorstep…

Managed funds

Managed funds are like ETFs, but actively managed by a person or a corporation. This makes periodic costs for managed funds higher than for ETFs. The added bonus is that the person will actively try to ensure the fund will perform well. Of course, even if the manager means well, this will not always guarantee the fund will match or outperform the market performance.

The risks of managed funds are low when sticking to A-grade funds. There are also a lot of risky funds that are not transparent about their investment strategies. These funds should be avoided like the plague. The website Morningstar.com is perfect for comparing funds. Managed funds are not speculative in nature.

Options

Options on the open market are like options on a house or a piece of land: it gives the right to buy something. Call options are a right to buy and put options are a right to sell. When buying a call option on a certain stock, the investor gets the right to buy those stocks for a certain price until a certain expiration date. If an investor decides to sell this right to another (also called “writing an option”), it means this investor is required to sell or buy stocks from the other if he or she decides to use this right. In short:

  • Buying a call option gives the investor the right to buy something at a certain price
  • Buying a put option gives the investor the right to sell something at a certain price
  • Writing a call option obligates the investor to deliver something at a certain price
  • Writing a put option obligates the investor to purchase something at a certain price

Options always have an underlying value and can be invested in with small budgets, with an added leverage effect. The risks are high because the losses can be severe if the investor is not careful. Investors can for instance write call options on stocks they don’t have in their possession. The maximum return on investment is the price received when writing these options, but the maximum loss is unknown. If the other party decides to use his option, the writer will need to deliver stocks he does not have. If the value of these stocks have soared, the writer will be in quite a pickle. There are many people who have gone bankrupt using this strategy. Don’t be one of them! Most brokers and banks today will actively warn new investors of these risks before making it possible to invest in options.

The risks of options are high, especially for inexperienced investors. Options can be a useful tool when used right. One good strategy is to protect stocks already in possession by buying put options. Even when these stocks plummet in value, the put options give the investor the right to sell the stocks at a fixed price.

Options are highly speculative in nature if used wrong. Another problem for long term investors is that the duration of most options is short. This also means options are not a good investment for passive and defensive investors.

Sprinters & turbos

Sprinters and turbos are like CFDs. With this asset it is possible to predict if a certain underlying asset will rise (turbo long) or fall (turbo short) in value. Just as with CFDs there is an added leverage effect, which means people can win a lot but also lose a lot if they are not careful. The main difference is that turbos and sprinters have a fixed stop loss level, while with CFDs the stop loss level can be chosen. A stop loss level is a certain value at which the asset is automatically sold to prevent people from losing any more money. The maximum loss for sprinters and turbos is 100% of the initial price.

The risks with sprinters and turbos are high due to the added leverage effect. This also makes turbos and sprinters highly speculative in nature.

Category What is it? Risk/Reward Speculative?
CFD Contract for difference High Yes
ETF Unmanaged fund Low to Mid No
Futures Future transaction at a certain value High Yes
Managed fund Managed fund Low to Mid No
Options A right to buy or sell High Yes
Turbos Prediction on rising or falling asset values High Yes

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