How derivatives can widen your market horizons

Certain alternative asset classes and strategies are tricky for private investors to access. Using derivatives – with caution – is one way to level the playing field.

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Throughout the rest of this supplement we've been looking at the sorts of alternative investments that could best be described as collectables, or even "trophy assets". However, there's another class of alternative investments, which might best be described as "financial markets that most private investors can't easily access".

For example, most of us own stocks and bonds in our portfolios. Some of us might own or have exposure to commercial property. And some of us (certainly the regular MoneyWeek readers among you) will own some gold (we reckon in the region of 5% to 10%). However, what happens if investors want to get direct exposure to commodity prices? Or to currency movements? To be very clear, we wouldn't regard either of these assets as forming a vital part of a core portfolio. For most long-term investors, when it comes to foreign exchange movements, what you lose on the roundabouts, you'll gain on the swings, while individual commodity prices tend to trend lower over time, as human ingenuity and improving productivity means that we can do more with less.

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That said, there are occasions when an experienced or adventurous investor might want to hedge their foreign exchange exposure, or to express a short-term view on a specific commodity, or simply to learn more about how a particular market works. So if you want to get exposure to these areas, what can you do?

The world of derivatives

The easiest way for private investors to spread the range of assets (and investment techniques) that they can access is by using derivatives. Specifically, there are two main types of financial derivative that offer ways to bet on prices (including the prices of individual equities and various different indices across the world): spread bets and contracts for difference (CFDs).

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The first thing to be aware of is that use of these derivatives is highly risky. Both involve using borrowed money to bet on movements on asset markets. This use of "leverage" or "gearing" means that gains and losses are both amplified. On the one hand, this enables you to generate significant exposure to a market with a relatively small amount of capital. On the other, it greatly increases your odds of being wiped out if the price goes against you. Indeed, technically your losses can be unlimited.

How does spread betting work?

While there are differences in tax treatment, which we'll go into in a moment, CFDs and spread bets work similarly to one another. In effect, you bet on whether the price of an asset will rise (in which case you "go long") or fall (in which case you "go short"). In the case of a spread bet, the provider(big providers include IG Index, City Index, and CMC Markets) will offer a quote, which consists of a bid (selling) price and a slightly higher offer (buying) price.

Say the FTSE 100 stands at 7,300, then the spread betting provider might give you the choice of selling at 7,299 or buying at 7,301. If you think that the index will fall or perhaps you want to hedge against the risk of losing money in your broader portfolio then you would go short, by selling the index at 7,299. You also have to choose a stake which is usually "per point".

You can also choose to close the bet at any time (at least, during market opening hours) you don't have to hold it for a specific period. So say you sell the FTSE 100 at £10 a point. If the FTSE fell by 51 points from 7,300 to 7,249, you'd make £500 (that's 50 times £10 remember you sold at 7,299 not 7,300, which is where the provider makes their money). On the other hand, if the index had risen to 7,351, you'd have lost £500. CFDs work on a similar principle, although the terminology is a little different.

Betting on commodities and currencies

As noted above, you can bet on many different types of asset using derivatives. From crude oil to copper, you can take directional bets on markets that you might otherwise struggle to gain access to. It's even possible these days to bet on cryptocurrencies such as bitcoin, although given how volatile these are, you'd have to be extremely careful in doing so.

Currency movements are another classic areawhere derivatives are used. When betting on movements in currencies, remember that currencies are traded in pairs unlike most other assets, the prices of currencies are always relative. The pound cannot rise or fall in a vacuum it has to be strengthening or weakening against another currency, such as the dollar or the euro. Placing bets on currencies can be a way to hedge against political outcomes (watch how dependent the pound has been on Brexit decisions, for example) or to bet on changes in the economic environment (all else being equal, for example, rising interest rates are likely to strengthen a country's currency whereas falling rates or money printing will do the opposite).

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The ability to go short is another way in which derivatives widen the range of strategies open to small investors. Just bear in mind that short-selling carries its own risks, above and beyond the risks of using leverage. If you are long an asset, your downside is technically limited to the point where the asset price goes to zero. But if you are short an asset, then your downside is technically unlimited there is no ceiling as to how high the price of an individual equity can go, for example. So be especially careful to monitor and manage your risk if you decide to dabble in the world of the short seller.

Watch your risks

You can see how losses can mount up quickly from what might seem like relatively small stakes and relatively small market moves. This is why your provider will insist that you have a certain amount of money in your account to cover potential losses. This is a deposit known as "margin". The size of margin required varies depending on how volatile the market is. If you have an open trade and it turns into a losing position, then your spread betting provider may demand more money to keep the position open this is what's known as a "margin call".

Of course, you really don't want to be relying on margin calls to get you out of trades before you lose too much money. That's what "stop losses" are for. You specify a specific level at which you want the bet to be closed. This still needs to be watched carefully though in particularly volatile markets, the price of an asset could burst through your "stop", leaving you with heavier losses than expected. You can pay more with some providers for a "guaranteed stop loss".

In terms of tax treatment, neither spread betting nor CFDs incur stamp duty. Spread bets do not incur capital gains tax (CGT) but CFDs do. On the one hand, that means you don't pay any tax on spread betting profits, but it also means that you can't offset any losses against your CGT bill for the year if you want to be able to do that, you should use CFDs.

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