Derivatives are a tool used by investors to manage risk. It is a complex area and one that requires a great deal of study and application to master. In brief, a derivative gets its value from another financial product. There are two primary types of derivative contracts: over-the-counter (OTC) derivatives and exchange-traded derivatives. They differ from each other in the ways they are traded on the market. There are also three major classes of derivatives: some types of warrants, futures and exchange-traded options.
- Futures. (Also sometimes called “forwards”) are contracts that say an asset block will be sold or bought on an agreed future date
- Options. An option gives the contract holder the right to buy or sell on a specified date in the future – but they are under no obligation to take up this “option”.
- Warrants. A tool used for trading on the stock exchange. They can be held over shares, currency, an index or commodity. Warrants (and options) allow the holder to earn additional income from their shares or to protect value of their existing assets.
Types of options
In Australia the different kinds of options available to investors include:
- Flex options
- Long term options
- Low exercise price options (LEPOs)
- Index options
- Index LEPOs
Types of warrants
There are also a range of different kinds of warrants commonly in use. They are:
- Equity call and put warrants
- Installment warrants
- Endowment warrants
- Low exercise price warrants
Options are traded electronically by brokers on a computerised market called the Derivatives Trading Facility (DTF). Using this system the first order placed is the first order processed and at the end of the day any unexercised orders lapse. Warrants are traded using the ASX share trading system.
The Australian Stock Exchange is a fantastic resource for further information about derivatives and also runs education classes for new investors. Alternatively, have look through the Investor Buddy Learning Centre or Derivatives section or email us.
