Private investors looking to accelerate the recovery in their portfolios after the financial crisis, are increasingly turning to retail derivatives to boost returns, say brokers.
Derivatives are financial instruments that allow investors to “buy” or “sell” the rights to underlying assets without having to purchase those assets. They also allow shorter-term traders to profit from falling as well as rising markets.
Covered warrants, contracts for difference (CFDs) and spread bets are the most popular derivatives among UK private investors, as they allow users to gear up their investments and avoid stamp duty on equity trades.
John Prior, director with the broker Killik & Co, reports that his clients are more interested in covered warrants, as they build in risk management: unlike spread bets or CFDs, they limit losses to the initial amount invested.
Here is a guide to boosting your returns with retail derivatives.
1. Covered warrants
These stock market-listed derivatives are best regarded as a simplified form of option. Call warrants offer the potential to profit if the underlying asset price rises; put warrants offer a profit if the underlying asset price falls. Like options, they allow investors to take advantage of “gearing” by giving exposure to an asset class for a small percentage of its price.
Each warrant has a strike or target price and a date for exercising the option. If the underlying price moves as expected, the investor takes a profit; if it moves against expectations, the warrant can be allowed to expire.
Underlying assets are usually equities or indices, but can also be commodities and currencies. As they are listed securities, the most a holder can lose if the underlying asset price moves the wrong way is the money put in upfront – a call warrant on an asset price that has fallen will simply expire worthless, at the end of its term.
Charges average 0.3 per cent, plus the dealing commission paid to a stockbroker. Because they are listed, the market for warrants tends to be more transparent compared with the spread betting market as the London Stock Exchange treats derivatives trading in much the same way as it does share trading.
“An obvious use of [a covered warrant] is buying a put option against a large holding of quoted shares that an ex-senior executive of a company needs to dispose of but needs to wait until he or she is nonresident for capital gains tax purposes,” suggests Jason Butler, a director with Bloomsbury.
“However, I’m not convinced that the vast majority of investors should be using derivative trading services, even if the downside is limited. This is because the cost of these services causes a friction against the returns from the whole portfolio and also brings in subjective opinion and judgment that even the professionals get wrong more than they get right,” he adds.
Among covered warrants’ disadvantages are rapid price moves and their lack of dividends. They are also subject to capital gains tax.
2. Spread betting
Financial spread bets offer a way of trading on an asset, such as a share or a commodity, or a market index, without having to physically own that asset.
Private investors place a bet with other traders that the price of an asset will go up or down. Spread betting firms quote buying and selling prices based on the actual value of the asset – plus their “spread” or profit margin – and investors choose to bet on their prices. For every point that the price moves in a trader’s favour, the trader wins multiples of the stake – but for every point it moves against the trader, a multiple of the stake is lost. Consequently, it is possible to lose more than the amount initially invested.
Profits on spread bets are treated as wins under the gaming laws so do not attract capital gains tax. Conversely, losses cannot be offset against tax.
Losses can be limited by paying for “guaranteed stop losses” that close a bet if a price falls to a specified level.
3. CFDs
CFDs allow investors to take a view on a share price or an index movement between the time the contract is opened and when it is closed.
They work in a similar way to spread bets: the issuer quotes a price range and the investor takes a view on whether the underlying share, index or commodity price will fall below or rise above these points.
CFD contracts have no fixed expiry date and can be closed at any time. However, because CFD positions are leveraged, the buyer is effectively borrowing money, so long positions incur interest charges. Short positions, conversely, earn interest. Deals also incur commissions though these are much lower than those that would apply to a share trade – typically around 0.25 per cent.
“CFDs should form only a small part of a portfolio and be considered within the framework of the larger portfolio, rather than simply as a means to punt on a stock,” says Tim Cockerill, head of research at Rowan, the advisory company.
