Demystifying Derivatives 

Financial derivative products can be a complex topic. There are several types of products and concepts to understand before investing. In this episode, we explore the basics to bring clarity to what can sometimes seem like a challenging topic to new investors. Nicholas Smith, VP of Sales at Eurex joins Cassidy Clement, Senior Manager of SEO and Content to discuss.

Summary – Cents of Security Podcasts Ep. 45

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to the Cents of Security podcast. I’m Cassidy Clement, Senior manager of SEO and Content and Interactive Brokers. Today I am your host for our podcast and our guest is Nick Smith, Vice President of Sales at Eurex. He’s based in the United States and we’re going to talk about financial derivatives today. And they’re a complex topic. There are several types of concepts to understand and you want to know about those before you start investing.  

So in this episode, we’re going to discuss these basics and try to bring clarity to what can sometimes seem like a very challenging topic to new investors. Welcome to the program, Nick. 

Nick Smith  

Thank you very much, Cassidy. 

Cassidy Clement 

So because this is your first episode, why don’t you tell the listeners a little bit about your background in the industry? 

Nick Smith  

Nice to meet your listeners. My name is Nick Smith. I have been in the industry for the last 7-8 years now, graduated from Aston Business School in Birmingham. My accent is British. I sound American to the British and British to the Americans. I’ve been here for six years. 

When I graduated, I started as an analyst at Deutsche Börse Group, which is the parent company of Eurex and Deutsche Börse is German for German exchange.  

They run a series of companies within the group, one of which is the one we’re to talk about today, Eurex, the German derivatives exchange. I emigrated to the US in 2018. I’ve been here since and been with Eurex for the last 18 months here stateside working with hedge funds looking to invest in derivatives. 

Cassidy Clement 

Well, then, you sound like the perfect guest for running over the basics of derivatives or going over that today.  

So let’s start out with some of the basics here. So if I was a listener and I’m just like, oh, I heard this term thrown around a bunch, I need to get some foundational knowledge. What exactly is a derivative and what are some of the types? 

Nick Smith 

Absolutely. That’s a great question. So indeed, they came from a background that is possibly outside of where you might think derivatives came from, looking at it from the outside in the modern day.  

I’d like to take your listeners back to being a cattle farmer in the Midwest.150-200 years ago. And thinking about it from the perspective of where derivatives came from. So the cattle farmer takes his cattle to market and agrees a price on that given day and is subject to the market price at that given moment. What they would then do is take the money, go back and raise another lot of cattle and bring them back to the market the following year.   

And a few cattle farmers got a little smart to this and said, well, ok, what if I were to speak to my seller and agree a price for next year? I’d be in a better position because then I’m not subject to the market changes. And I would simply have a piece of paper that says yes, I’m willing to buy your cattle at $100 bucks a stee or what have you for the future. 

And you’d be able to say, ok, I am solid for this amount of money down the track. That’s essentially a Futures contract where you’re making an agreement to exchange an item at a later date at a given price. And that is exactly what the Future is in the modern day. But the underlying has gone beyond cattle to all sorts of different instruments.  

So a future, as defined by the textbook, would be an instrument whose value is dependent on the value of an underlying asset. And so that Futures contract that that cattle farmer holds at that moment in time, they then have a value to that contract based on the market price of cattle.  

So as I said, for example, if you had a contract that said the cattle is worth $100 in the year’s time, but the actual market price is only $70.00, then that farmer is in the clear by $30.00. That is the value of the Futures contract. So like I say, there are many different Futures contracts available today. So you might have contracts on rates, interest rates, you might have contracts on government bonds, you might have contracts on equity indices, which I’m sure you’ve covered in other podcasts, and that would be the value of the overall equities within that index.  

Derivatives go beyond that, though. There are different types of derivatives, so there’s Futures as we just mentioned. Options as well. So Options is where instead of having an agreement to exchange the item at a given time in the future, you have the decision whether or not you would like to do that. And the holder of that option can make that decision whether or not they want to exchange the underlying for the value as prescribed, which is called the Strike price in the case of Options.  

Finally, another one to comment on would be Swaps. Swaps is where you also take the value of a certain underlying, but you exchange it for something else. So that might be a rate Swap and you say, okay, a variable rate such as a base rate of a central bank, I’ll exchange that for a fixed amount.  

And similarly, the reason this is categorized in the same category as Futures and Options is the Swap has a value based on where that rate is prevailing at the given moment. So that’s Futures, Options and Swaps. 

Cassidy Clement 

Well, you covered most of the items that I would have said, too! So, when we’re thinking about derivatives for listeners, if you are somebody who looks to maybe linguistics or the way that words are, think about derivatives. What’s in that word? Similar to derive. So it derives itself from a value maybe of an underlying asset, group of assets or a benchmark.  

So when we hear these things..you did a great job of explaining them, but I’m sure people might say, okay, great, I get it. They’re kind of getting their value from somewhere else. But how exactly are the prices assigned? And like, is there a certain process of calculating that? How would you explain that? 

Nick Smith 

That’s a great point. So indeed, the pricing of derivatives is a complex topic. I think the exchanges provide probably the cleanest example of how those can be calculated. And I work for Eurex, which is the German derivatives exchange, been around for 25 years since last year. And we have a number of Futures and Options contracts available on the exchange. Now what’s the exchange? Well, we talked a minute ago about Futures contracts in the context of what perhaps a non-standardized Futures contract would be, which would be termed a Forward.  

A Futures contract, by comparison, is a standardized version of Forward. And those get traded on exchanges. That allows people to buy and sell those Futures contracts. So you’re that cattle farmer, you have that contract in hand. What if you want to get out of the cattle farming game?  

Well, you can sell that contract to your buddy and say, hey, I’ve got this contract that says someone’s going to buy this for a period of time. Problem is maybe their cattle are slightly different to your cattle and all these things.  

The exchanges provide that mechanism whereby you can trade these contracts like for like and those contracts at that standardized level. So with a standardized quantity, a standardized deliverable, which is the deliverable of the underlying. Those are then what we call fungible. Fungible means you can trade them like for like as described.  

That means that on the exchanges, people are exchanging these contracts with one another based on whether or not they want to be in that position or out of that position. They then come up with a price. You exchange those at a given price. That is an example of how the price of Futures is created in the exchange.  

In the case of Options, it’s a little different because you’re going to have a series of Strike Prices. And that’s where determining the exact way you would like to be in the market, ie. what price you would like to assign to this option at expiry or as I mentioned, the Strike Price.  

You can pick your Strike price. I would like my cattle to actually be worth $120. But that option might cost you more because you’re asking for a higher Strike Price. Or less because you’re asking for a lower Strike price.  

So, Options is a little different because there’s a matrix of Options around those Strike Prices. And then Swaps are not traded on an exchange. By comparison, Swaps are agreed bilaterally. Now they have some standardized protocols by which you might use to create those Swap positions.  

But by comparison, those Swaps are engaged in bilaterally and therefore those prices are determined by the two parties in question. 

Cassidy Clement 

So how exactly are derivatives taxed, since there are a few different types? 

Nick Smith 

Derivatives, as mentioned, have these values that are dependent on other values. And the valuation of derivatives is a topic that has been extensively discussed and continues to be extensively discussed by lawyers, taxation bodies and the traders themselves. 

I think when it comes to Futures, it’s a little simpler. When it comes to Options, it’s quite complicated and your listeners will be aware of all the different Options valuation models. That would be the value of those positions and holding those at the given time and how the taxation is then put on the value of that. Just like you might own a house and the taxation would be on that. But then when you come to sell that house, obviously the gains and losses you make on that are also taxed as income. 

Cassidy Clement 

So now let’s talk about the current derivatives market since that’s what you work in every day.  

Where could investors actually find and buy derivatives? And have the exchanges that offer these been around for a while or are these relatively new areas that people have gotten into? Let’s say, I think you mentioned you guys have been around for 25 years.  

Is it kind of that new for most people buying them? 

Nick Smith 

It’s a great point, Cassidy. So indeed. As it relates to your Eurex, we are 25 years old. That’s not to say that the European derivatives market is so new. In fact, I think in Europe the cattle farmers in the Midwest example has replaced with poppy sellers in Belgium 700 years ago. These markets have been around for a long time. In the modern formalized way by which your listeners are able to access these markets, there are a number of key exchanges around the world whereby the exchange traded derivatives ie: those Futures and Options can be bought and sold.  

So Eurex being 25 years old. In the US there’s also the Chicago Mercantile Exchange, CME. That’s a very common one where the US Treasury Futures are traded. So that’s Futures on the U.S. Treasury debt, ie: U.S. bonds. They merged with the Chicago Board of Trade in 2007. Chicago Board of Trade is the legacy exchange whereby the traders hold up cards, what we call open outcry. These days an awful lot of trades are done digitally. Eurex, for example, never had a trading floor. We’ve always been on computers. We merged with the Chicago Board of Trade in 2007 to form the group that we see today with the active Futures market there. Cboe is another one in Chicago, which was formed in 1973. And ICE, the Intercontinental Exchange, was formed in 2000.  

So those are the types of exchanges that investors can go to. But I think what’s key when thinking at this from an investor point of view is that you can’t just turn up to the exchange and say, hey, I want to trade.  

Back in the day, you would buy a seat at the exchange and say, hey, I would like to sit at this exchange and hold up my card. These days the process is a little different. What any investor needs is what we call a prime broker or in Eurex terminology, a Clearing Member. We’ll come on to Clearing in a moment. 

But the Clearing Member, essentially is a bank that takes on the responsibility of the risk of the positions that you’re putting on the exchange. You are then beholden through the bank for the economic outcome of those positions.  

And so it’s important to find what’s called a prime broker if you’re an investor. Those prime brokers are large, big box names that you’ve heard of on the street, but there’s also opportunities like Interactive Brokers, like Robin Hood, like others, TradeStation for example, where retail investors can also get involved in the Futures and Options market. 

Cassidy Clement 

So there’s several different ways I guess you mentioned there that investors can get exposed or see if the trading of derivatives is for them. And if it’s even offered.  

What are some strengths though, or areas of focus that investors would kind of look towards for these derivatives? We mentioned all their details and how they get their value and so on and so forth. But what exactly would people be saying ah yes, that’s what I use derivatives for? 

Nick Smith 

I’m going to touch on that and one other thing that I think is crucial to that. So when it comes to why investors use these tools, the two main examples that we talk about is hedging and speculation.  

So in the case of hedging, that’s where you say okay, I’m not exactly sure where this outcome is going to go. And let’s go back to our cattle farmer. He doesn’t know whether the market price is going to be 50 bucks, 5 bucks, 500 bucks, whatever.  

But he does know that if he’s able to sell his cattle for $100, he’s good for the next year. So it will be a logical thing to enter into that contract for the small fee that it would cost them to do so. And say okay, I’m secure for a future date.  

The same happens the world over in corporations, in banks, in hedge funds where they say, okay, I’m interested in making sure that my position is secure at a future date and derivatives are a great tool for that and they’re low cost. Now the low cost is associated with the fact that when you hold a derivative position, you’re not actually paying the whole amount.  

So let’s take an equity index derivative as a great example of this. You don’t have to go out and buy the entire S&P 500 or the NASDAQ 100. You don’t have to buy individual portion of each security. You’re able to instead use these to expose yourself to the changes in those securities, which fundamentally is what a hedge is looking at, right?  

They’re not necessarily interested in the underlying value. More so the change, because that’s what they’re hedging. So that’s where Futures and Options become a great opportunity for doing that. And the low cost comes from the fact that you post margin to those positions.  

Now, what’s margin? Margin is the amount that the exchange requires. Each exchange that I mentioned has associated with it what’s called a Clearing house. Those Clearing houses is where we conduct the risk calculations, deciding what is the value at risk that each investor has in these positions. And the exchange requests a certain amount. That amount is called margin and that is an amount that secures your position over a certain period and risk parameters. That’s really the risk at play, but obviously there can be more money required if the underlying asset goes in a particular direction.  

Certain situations where you may find that actually what’s called a margin call is necessary, whereby the exchange requires of the prime broker and then the prime broker requires of the end investor an extra top up to say hey, actually, you’re going to owe us more at the end of this derivative.  

So if you hold this position for a longer period, you’re going to have to put up extra money. But whilst that sounds a little daunting, at the end of the day, that’s still an awful lot cheaper than having to go out and buy all those underlying securities.  

It’s a really fantastic tool for hedging when you’re not sure about the move of the market down the track and you want to post a certain amount of margin to that position for simply hedging the change, rather than necessarily getting involved in the underlying market.  

On the other side, there’s speculation that I mentioned. So speculative investors common the world over and that would be someone who goes on to their Interactive Brokers trade station account or what have you and says okay, I think that the market’s going to move in a particular direction.  

Am I thinking about it going up or down? And then I will put a position on accordingly. The great thing about derivatives is that when it comes to looking at equities, for example, if you’re looking to short sell an equity, you have to borrow that security and then sell it and then buy it back and give it back.  

When it comes to Futures, Futures and Options, you’re able to take a short position, whereby you’re saying, okay, I do believe that this is going to go in a negative direction.  

So you don’t have to be long only the whole time. You’re able to say, okay, I think it’s going to go down. So you can be short a Future, long a Future. Ditto with Options, with the buyers of calls and puts, which we can talk about in more depth.  

And that gives speculators the opportunity to participate in a market dependent on their view, without necessarily, again, having to get involved in the underlying securities, which gets even more messy when you’re trying to go in a particular direction. 

Cassidy Clement 

So quick plug for us. We actually do have an Options intro type podcast, where I believe it’s Options how to get at the money. We go through all of these kind of root pieces and Options. Because as Nick mentioned, it is very complex and that in and of itself absolutely can be and is another podcast.  

But you mentioned a lot of different strengths or pieces that people look towards derivatives to utilize them as tools, but they’re not always for everybody. So what should investors ask themselves when they’re considering derivatives as an investment? 

Nick Smith 

Absolutely. So an investor should look to what I mentioned around what are they trying to say in the market? I always think of derivative positions as, in one way or another, an expression of an opinion in a financial instrument on an exchange with a Clearing house.  

Ultimate point around derivatives is that they are more leveraged. And we talked about the fact that a hedge is able to access a change in the market at a lower cost than necessarily participating in that market, which is great.  

But that being said, when you’re talking about a Future or an Option, particularly an Option, which might be not at the money but out of the money, for example. You could be beholden for a large sum of money at the end of that, if indeed you’re the wrong way out. It’s important for investors to consider whether or not they’re okay with that risk and what they’re gaining out of that. And whether they believe the market is going in the correct direction for going in that way.  

These tools have a value based on underlying, but they’re not an underlying themselves in most cases. And that means that there is this concept of what we call leverage. So indeed for the amount that you’re putting up, the risk is greater than if you were to go out and buy your blue-chip equity stock.  

Cassidy Clement 

As always, with most investments, there are different types of drawbacks and strengths and, of course, various risks. So always do your homework.  

As always, we thank our guest Nick for joining us. 

Nick Smith 

Thank you very much, Cassidy. It was great to be on. 

Cassidy Clement 

Sure. So as always, listeners can learn more about an array of financial topics for free at ibkrcampus.com. Follow us on your favorite podcast network and feel free to leave us a rating or a review. Thanks for listening everyone.