Lesson 2- A first view of Derivative Products

Derivatives are by-products of the actual shares. Let me explain with the example of Pete’s business, using warrants.

Roger notices that Ivan sold is share to Melissa for R2500. He knows that Melissa expects Pete’s business to do more and more international placements, therefore she’s expecting a higher dividend and was willing to pay more for the share that will give her that dividend.

But Roger also expects the job market in South Africa to improve, which might cause a profit reduction for Pete’s business, as more people will find jobs locally and won’t need to go overseas. He approaches Melissa with the following proposal:

“Melissa, I will give you the option to buy my share in Pete’s business for a price of R2200 on 1 December 2005. However, to reserve that option, I’m asking you R350 for the option. “

Melissa thinks it through: “This means I have to pay R350 for the option, to buy the share in December 2006. If I buy it then it will be at a price of R2200. That means my total costs for the share will be R2550. Not too bad – I’m sure the dividend will be big enough to cover the costs. The share should probably be worth R2800 by then – Pete is doing good business.”

So Melissa pays Roger the R350, and he gives her a note saying:

“I hereby give the holder of this note, the option to buy my share of Pete’s business, at R2200 on 1 December 2006.”

Roger’s expectation of a better job market failed to impress: Even more people were looking for jobs in the UK by October 2005. Pete’s business is doing better than expected. The dividend expectations are now much higher. People are willing to buy the shares at R3000.

Melissa however needs money for a new car, but does not want to trade her shares to fund the car – she wants the dividends that will be paid soon. She remembers the option she has to buy Roger’s share at a good price. She does some calculations, and approaches Ivy with this offer:

“Ivy, as you know, Pete’s business is doing very well, earnings are up, and dividend expectations are very promising. People are willing to buy the shares for about R3000 now. I have an option to buy shares at R2200. This means I can get the share cheap compared to the current market value. I will transfer this option to you for a cost of R700. It’s a good deal!”

Ivy does this calculation in her head: “The share is worth R3000. I would be paying Melissa R700 for her option to buy the share at R2200. That means I can get the share at a total price of R2900 which sounds like a bargain!”

Ivy is eager, and buys the option from Melissa.

The option, or warrant, is something they now started to trade. Ivy may sell this option at an even higher price if the share price further increases. If the share price drops too far, she can choose to not exercise the option, thus loosing only the R700 she paid, and not the share itself.

Something important to note, is the increase in share price, compared to increase in the price of the option, or the warrant’s price:

The share price increased by 50% from R2000 to R3000.

The warrant price increased by 100%, from R350 to R700

This means that the warrant price climbed 2 times more than the share price. This principle is called gearing, and sometimes it is referred to as leverage:: For every 1% increase in share price, there’s a 2% increase in warrant price. This would be a 1:2 gearing.

The reverse would also be true: For every 1% drop in share prices, a 2% drop in warrant prices would occur.

These ratios differ from warrant to warrant, and will be explained in full in the section on derivatives at the end of this course.

For now it’s important to understand the principles of leverage or gearing.

For further explanation of leverage or gearing, a last example of leverage could be a rental property purchase. Assume you find a building for sale for R250000. You have R25000 cash, which is 10% of the total purchase amount. You pay a deposit and the bank finances the remaining R225000. The money you contributed is in a 1:9 ratio with what the bank supplied. Your R25000 was geared 1:9 (for everyone one rand, the bank supplied 9).

The power of leverage or gearing can be seen when you sell the property. Assume the tenant paid rent equal to the monthly installments you had to pay to the bank, and also the levies.

After two years the property is worth R390000 and you sell it. You settle your bank load which is on standing on R215000 by that time. The difference is R175000. You will have to pay capital gains tax on this amount.

However, you’ve made R175000, by getting a 25% annual growth on a property that was worth R250000, for which you invested only R25000 from your pocket!

You do not have to be in stock market derivatives to make use of gearing. However, stock market derivatives can offer you the benefits of both gearing, as well as profits using put options when the markets are going down.

A word of advice: Warrants are not as liquid as shares. In other words, you might not always find a buyer for your warrant. Warrants therefore carry a greater risk, partially because they are less liquid, but also because losses will also be amplified because of the gearing effect.

Warrants are more complex than this, but after reading through chapter 11 you should be able to start using these instruments with relatively low risk. However a few things worth noting about warrants are:

• They are short term trading instruments: They have an expiry date and it is best to trade these instruments only if the expiry date is more than 2 or 3 months in the future. The further that date is, the less risk that you will have to sell at a price
• Because of the gearing effect of warrants, you can use much smaller amounts to get the same returns as you would have from buying shares valued at a higher level. For example, with R2000 you can make R300 within a few weeks, whereas to make this by owning the share, you would have had to buy R10000 worth of shares.
• When you buy a warrant you never own the underlying asset (the share of ownership). You only own the option to buy or sell it at a certain price on a certain date in the future.
• Warrants are highly volatile, their prices could rise or fall 10% in a week easily.
• Warrants can tempt you to become a gambler. Do not substitute good analysis practices for taking a chance on a warrant with a price that dropped and you assume it will recover well. Do the research first.
• Warrants are less liquid than shares. In the share market there's almost always a willing buyer to take over your shares. On the warrant market you might have a bit more difficulty selling.

Practical Section

Page through the list of share prices in your business section of the newspaper. Try to highlight the 10 or 20 "biggest" companies. How do I know which are the biggest companies? Look at the Market Capitilisation column. Market capitalisation is the value of each individual share multiplied by the total number of shares in issue.

These companies are also the likely ones to have warrants issued. These derivative products are not issued by the companies themselves, but by companies such as banks!

Also try to see the trading volumes of these companies, you will notice they are also normally high. This is something to keep in mind: High volumes means the share is "liquid", meaning, it sells easily. If the share is highly liquid, likely so will be the derivative products.

In || LESSON 3 >> we'll look at how to read the economy in order to gain an understanding into the arena our business in which we hold shares, must make a profit.