In the last few months of 2002, traders have seen somewhat of a return to those heady bullish days of the late 1990s and early 2000s, with markets recording considerable gains, day after day.
Volatility and weakness provides many opportunities and it is through the utilisation of clever, yet simple derivative instruments, that opportunities can be grasped.
David Butler, chairman, Global Trader 247
This followed through into the first week of this year, where traders saw 8% gains and more, in many of the international stock indices. But then the rally stopped. Or to put it bluntly, it reversed and started accelerating aggressively to the downside.
This time however, it is not accounting scandals or poor corporate results which are leading to weakness, it is the rapidly deteriorating situation in the Middle East which is creating such great uncertainty.
Nor does this issue appear likely to subside anytime soon, hence we can expect continued weakness or at least significant volatility in the near term.
This substantial and sustained weakness, bearing in mind that we are about to enter a fourth year of a bear market, is playing havoc with a wide range of traditional sectors of the financial community; in particular the insurance industry where each day of stock market weakness elicits further selling from many of the major insurance players.
Indeed a substantial part of the most recent spate of selling has been attributed to these insurance companies selling in order to meet statutory requirements. The traditional stockbroker, another cornerstone of the financial community, is also feeling some serious pain. These companies in particular provide a very limited service whereby their clients can predominantly only buy stocks or bonds, or sell existing holdings which they have.
Needless to say, in times such as these, brokers` telephones are not very busy.
However, all is not lost for participants in the financial markets. Volatility and weakness provides many opportunities and it is through the utilisation of clever, yet simple derivative instruments, that opportunities can be grasped.
A good example is the use of interest rate derivatives to fix interest rate exposure such as a bond or mortgage. With the weakness in the equity markets, bonds have put in a remarkable performance and international yields are at record lows.
Through a relatively simple interest rate derivative a bank can facilitate you fixing your bond interest rates, and hence your monthly mortgage at a substantially lower rate then your current variable rate and for a long period of time. Immediately this leaves you with more money in your pocket.
Contracts for difference
Another is a 'Contract For Difference` (CFD). A CFD allows you to reap significant rewards in current times. It is a derivative instrument that exactly mirrors the price movement of an underlying share. It is essentially a mirror image of a share. So if a share moves from 10.05 to 10.45, a CFD will also move up by 0.40. Similarly if a shares moves down 10.05 to 9.65 then the CFD will also move down by 0.40.
The burgeoning "small-hedge-fund" industry in the UK and North America has embraced this instrument with great success, which has led to an industry growth of 60% year on year
David Butler, chairman, Global Trader 247
The difference with CFDs however, is that you do not need to own a CFD to sell it first! So you can sell at say 10.05 (even though you don`t own it) and buy it back far cheaper, thereby locking in a profit. So CFD traders, or Spread Traders, can gain whether a market is going up or down.
The burgeoning "small-hedge-fund" industry in the UK and North America has embraced this instrument with great success, which has led to an industry growth of 60% year on year.
However, making money in falling markets is not the only benefit of trading CFDs; their efficiency is also a great advantage.
Since a CFD is a mirror of an underlying share, and not a share itself, there is no laborious scrip lending, nominee account maintenance or delivery of such things; it is simply an electronic agreement between the provider and the client.
Since it is far more efficient it is also far cheaper. With the massive volatility in the markets that we are witnessing, shares within industries have a tendency to step out of sync with each other; CFDs provide an ideal way of taking advantage of this.
Due to them being so efficient they can facilitate capturing even the smallest pricing irregularities between shares: if Gold Fields falls too much relative to Harmony in a trading session, then a CFD can facilitate buying Gold Fields and at the very same time sell Harmony, anticipating that relative to each other they will come back into line. Even a fall out of sync of as little as 2% can provide significant money making opportunities."
So all is not lost for the savvy street-wise investor. Derivative instruments, if used in the correct manner, can be intelligent tools to make some serious money. If we embrace them, as many of the smaller hedge funds and private investors have done, they can benefit us tremendously in today`s current market.
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