How to rack up those gains

Highlights in this issue:

*** The truth about derivatives...
*** Get exposure to retail bonds...
*** Are you best in cash...? and more...

From the overworked laptop of Julie Brownlee...

Dear Investment Academy Reader,

After last week's fly through shares, share instalments and ETFs, here are the rest of the vital components for your portfolio - with a bit more risk chucked in!

Financial derivatives

There are many financial instruments that fall into a specific category called derivatives. Here are the two most common derivative products available to you as an investor: Warrants (also known as options) and futures.

Definition: The simple truth about derivatives

A derivative is a financial instrument whose market value ultimately depends on (or derives from) the value of another investment security. This security is called the underlying asset.

I’m sure you’ll agree this is a fairly simple definition. However, financial derivatives are far from simple. They’re incredibly sophisticated financial instruments and you need your wits about you to trade them effectively.

Definition: What are warrants?

A warrant is a financial instrument that gives the holder (purchaser) the right but NOT the obligation to buy or sell a certain quantity of an underlying asset (share) at a future date, for a price determined at the warrant’s inception.

I’m sure the example I’ve included below will make things a bit easier to understand.

The great thing about warrants is they allow you to take a bullish or bearish view on the market. If you think a share's going up in value, you can "buy" a call option. Alternatively, if you think the share's going down in value, you can "buy" a put option. When you buy these warrants you’ll have to pay a price (called the premium). Because this (premium) merely secures you the right to purchase a certain amount of stock at a future date, this is the maximum amount you can lose.

Keen to get some warrant action?

I’m sure you’re familiar with South Africa’s own cellular giant MTN. Let's say this share is trading at around 12,000c. If you thought the share was going to go up in price, you could phone your broker and buy the share directly on the Johannesburg Stock Exchange. A thousand shares would cost a respectable R120,000.

Otherwise, you could determine what warrants are issued over MTN shares at the time. Most online brokers allow you to search through the myriad of warrants issued on a particular share. Because you think MTN is going up in value you’ll buy a call warrant. (Remember, it’s imperative you choose the most suitable warrant from the available listed warrants.) If you intend trading in warrants, I suggest you consult with an expert on the topic...

In our example, you’d select an appropriate call warrant and buy enough warrants to give yourself exposure to the 1,000 shares you'd have purchased outright. To make the example complete, let's say you select the MTNNBG (a Nedbank call warrant on MTN) with a strike price of R120 and an expiry date in September 2009. You need ten warrants to exercise an option on one MTN share at this price…

Warrants aren’t my favourite financial instrument. While they give you the ability to multiply your profits, problems with volatility, liquidity and time decay can leave you with very quick and very damaging short term losses. I suggest you consult with an expert in the field before electing to trade warrants.

At the very least, take some time to fully familiarise yourself with this financial instrument before buying or selling...

Financial derivatives – singles stock futures (SSF)

The single stock future is yet another derivative product that derives its value from an underlying share or index. Single stock futures are a product of the South African Futures Exchange (Safex) – and can be traded by private investors through any Safex registered broker.

Like options (warrants), single stock futures give you the opportunity to take advantage of a rising or falling stock market. If you think the market's going up, then you "buy" (or go long) a particular single stock future. If you think the market's going down, then you "sell" (or go short) a particular single stock future Single stock futures also offer you the opportunity to leverage or gear your trades by a substantial amount. Each 1% gain in the underlying asset (share or index) will result in a gain of between 6% and 20% depending on the conditions of the transaction.

Definition: What are futures?

A futures contract is an agreement to buy or sell a fixed quantity (usually one contract) of a specific commodity or financial instrument, at a standard future date at a price agreed between parties to the contract.

And here’s the interesting detail... With a future, you don’t have the option of fulfilling the terms of the contract. You’re obligated to fulfill them. That means if you choose to buy ten MTN futures contracts, you’ll have to take delivery (and pay for) 1,000 MTN shares on the agreed date... Each futures contract is for 100 of the underlying shares – so one MTN contract would give you exposure to 100 MTN shares.

Example: Buying a futures contract

To explain I’ll use the example of a short trade (sell) in Sappi. Let's say you’ve been reading the news on a regular basis and notice Sappi is running into a great deal of trouble thanks to falling paper prices in North America and Europe. You also notice it's trading at a very expensive price earnings ratio. Everything is pointing to a fall in the share price.

Here’s what you do. You telephone your Safex broker and ask him to sell ten Sappi futures contracts at R22 on the underlying. You’ll have to specify the month you want to trade (usually March, June, September or December). Your broker will let you know the margin for each contract, and will execute the order on Safex.

Let's say the margin per Sappi contract is R250. Thus, for ten Sappi contracts you’ll have to place a margin of R2,500.

Gilts (or bonds)

Bonds are one of the often neglected areas of personal investment portfolios. This is strange considering the total market value of the bond market is far greater than the market value of the stock market.

In South Africa, bonds are regulated by the Bond Exchange of South Africa (Bondex). This exchange is responsible for the regulation and trade of bonds registered in the domestic market. These bonds are mainly issued by government or by larger South African listed companies.

Bonds are a difficult concept to grasp for the beginner investor. However, you’ll find your understanding of this form of financial instrument will be greatly advanced if you get the basic concept right.

What you need to know is that bonds are classified as fixed income securities, because they impose fixed financial obligations on the issuer. (In English, the person raising money by "selling" these bonds won’t only be paying you a fixed amount of interest, but will have to repay you the amount you loaned them too!)

Essentially, when you "buy" a bond, you’re acting as a bank! Yes – that’s right – by purchasing a bond you’re agreeing to lend money to a government (or a company in the case of corporate bonds) in return for a certain fixed amount of interest...

There are a number of concepts you need to familiarise yourself with in order to gain a basic understanding of bonds. They are listed and explained below:

The basic building blocks of a bond

The coupon is the interest rate that you (the investor) will receive for the duration of the bond issue. This is also known as the interest income or nominal yield.

The maturity is the number of years before a bond expires. Most bonds have a single maturity date and are known as term bonds.

The principal value is the value of the original obligation (also called the par value). In other words, this is the amount you would have paid if you took up the bond at the date of issue. It isn’t the same as the current market price of the bond.

There are various types of ownership for bonds, either bearer bonds or registered bonds. The only difference here is that with the bearer bond the issuer keeps no record of ownership.

To sum up, a bond is quite simply a form of loan that you make to the bond issuer. The issuer is most often the government or a large company. You’ll pay a principal value (if you’re buying a new bond issue) or a market price (if you’re buying a bond on the open market). In return, you’ll get a coupon interest rate which will be paid to you twice annually until the bond matures...

The bonds most often talked about in the financial press are government bonds. These include the R153 and R184. Corporate issuers of bonds include Telkom, Transnet and Eskom...

I’m not expecting many of you to become active in buying and selling bonds. That’s not the purpose of this article. Perhaps your financial advisor will decide it’s necessary to include some bond exposure in your overall investment portfolio. In this case, there are many more ways to gain this exposure than there used to be.

There were times when you could only trade bonds in lots of R1 million. Today there are many alternative methods to gain bond exposure.

Government Retail Bonds

If you’re looking for a quick and easy entry to the bond market, then consider Government Retail Bonds. This is the South African government’s attempt to make the bond market more accessible to the private investor.

They offer a quick and easy solution to the private investor looking for reasonable yields in the short- to medium-term. Government Retail Bonds can be purchased for periods of two, three or five years. These bonds can be purchased in fixed units of R1,000.

The interest rates are fixed at the date of purchase. You’re can elect whether to have the interest paid out bi-annually, or whether to reinvest the interest in the bond.

What I really like about this product is how easy it is to purchase. You can simply walk in to your nearest Pick 'n Pay or Post Office branch and make the purchase over the counter. Alternatively, you can purchase these bonds online on their website.

Cash

This is possibly the asset class best known to the average investor. It’s the most risk free form of investing – and carries the most disappointing return. There are many forms of cash deposit accounts offered by various financial institutions in South Africa. The big four banks are extremely competitive, so you can expect a similar range of products regardless of which institution you choose to deposit your funds. But, you'll still need to spend some time and effort negotiating the best rate with your bank though!

Most of you will choose to keep as little as possible of your funds in cash. You should only keep enough cash for emergencies – and seek alternatives with better returns for the balance of your available funds...

Cash can be held in savings accounts, notice deposits, call deposits, fixed deposits and money market accounts. The interest paid on these accounts varies based on the time the money is committed to the account and the amount of money in the account. Many of these products carry penalties for early withdrawal – so make 100% sure you understand how the product works before investing.

Act now

Confident investing is all about obtaining and maintaining your knowledge of the various types of investment opportunities available to you. Take some time out of your schedule to research a few financial instruments in your own time.

Until next week - happy trading!

Julie Brownlee
for the Investment Academy