Deriving value from derivatives

Investing in the futures markets provides a number of inherent advantages to individual market participants and businesses alike. It goes without saying that (with the right trading strategy) investing in commodity and FX futures provides excellent speculative opportunities for those looking to develop an alternate revenue stream. For investors who have a strong financial base (and as a result, have more holding power), trading in the derivative markets might prove to be a highly lucrative and profitable venture. However, investing in the derivative markets can also provide significant opportunities for entities looking to add additional value to their existing core businesses. In order to have a better understanding of a futures exchange can add this value and provide investment opportunities, lets revert to the basics and see how it matches up to the typical stock exchange.

Just as stocks are bought and sold on an exchange made up of stockbrokers, so too commodities and currencies can be bought and sold on an exchange made up of futures brokers. In both markets, participants put forward their buying or selling prices through their brokers, and once the price is met in the market, the order is executed.

However, the futures market has some additional advantages that say, the local equity markets do not provide. Take for example, the notion of going 'short.' If the expectations are for a certain currency or commodity to weaken in the near future, a trader could take advantage of this view by taking a short position (selling a position before buying) and covering that position at a profit once the market has dropped low enough. Other than being able to trade both sides of the market and potentially profiting from both uptrend and downtrends alike, futures markets provide the all-important tool of leverage.

The fact that futures are highly leveraged financial instruments means that an investor can enter the market with a small proportion of the actual capital required. In essence, by investing a small margin amount, an investor can take a position of much larger worth through the concept of leverage that's offered in futures markets.

Although leverage can greatly increase an investor's earning potential, it is important to note that it can act as a double-edged sword and can also substantially magnify an investor's potential losses.

This is why such leverage and exposure needs to be managed very carefully, just ask Jérôme Kerviel, the man behind Soc Gen's €4.9 billion (Dh loss back in January 2008. But leverage and short selling advantages aside, perhaps the most intriguing value that the futures markets can present to market participants is in the form of hedging. In the simplest of definitions, hedging is defined as an attempt to offset exposure to price fluctuations with the goal of minimising one's exposure to unwanted risk. To understand this concept, we can look at an example of the very grass-root of levels. Due to the peg of the Emirati dirham to the US dollar, we all are exposed to that risk of a weakening Greenback which means our hard earned dirhams become weaker too. Trips back home to visit loved ones or family vacations to Euro Disney suddenly become that much more expensive.

Now surely the impact of such currency fluctuations are minimal for individual consumers such as me and you, but when looking at some of the businesses headquartered in the region who have a physical exposure currency exposure in the millions, hedging in the futures market can present such entities with a way of reducing their losses to such currency fluctuations and stretching their profit margins just that little bit more.

Importers and exporters who are based in Dubai and are required to pay their European suppliers in Euros can offset their exposure to fluctuations in EURUSD by taking a leveraged EURUSD position in the futures market. Let's quantify the potential for gain by looking at an example.

Let's say I'm importing some of the finest marble with a total worth of €1 million from my supplier in Carrara, Italy. Let us also assume that at present EURUSD is trading at 1.3200 and my payment is due in three months time from today.

Assuming I don't use the futures market to lock in my price, I face the risk of EURUSD appreciating and being more expensive come payment time-if in three months EURUSD appreciates to 1.3500-I stand to lose close to $30,000 (Dh110,100) just in volatility in EURUSD (that's three per cent of my total invoice).

Sure I could've have taken the risk with the view that the EURUSD would be weaker in three months time, but the concept of hedging is to reduce this unnecessary risk. Through this simple example, I stand to pocket close to three per cent of my total invoice value and reduce my overall risk exposure.

Using the commodity and FX futures markets provides each of us specific investment opportunities whether it be for speculative purposes or hedging purposes. And in the current market climate, driven largely by uncertainty and price volatility across all the asset classes, taking advantage of these opportunities can add value and could stretch those profit margins just that bit more.

- The author heads the DGCX Futures & Options trading desk at ACM ME DMCC. The views expressed are his own

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