04 Complex financial products

In addition to the basic financial products covered in the previous lesson, you might have heard of more complex instruments, such as options and leveraged products. These investment products are not suitable for beginning investors because they come with a higher risk of losses. Nevertheless, this lesson will briefly introduce these products so you have a better understanding of the purpose they serve, and the risks that are involved.

Text version

person thinking if the stock will go up or down.

An introduction to derivatives and leveraged products

There is a wide range of financial products to choose from if you start trading, including very complex ones. Examples of these are options and leveraged products. These investment products are not suitable for the beginning investor, because they come with a higher risk of losses. However, we would like to briefly introduce them so that you better understand the risk involved.

Derivatives

If you are the owner of a stock, you also own a corresponding part of that company. But there are also investment products that derive their value from an underlying asset or product, such as a stock or commodity. These products are aptly named: derivatives. Experienced traders can use derivatives to speculate on price movements, or to hedge risk. Although derivatives can in some cases achieve a high return, they typically also come with high costs and risk.

Options

A common example of derivatives is an option contract. If you have a certain expectation about how the price of a stock will change, you can trade on this belief using an option. As the name suggests, options give you the right to buy or sell an underlying asset, like a stock, for a fixed price at a predetermined date in the future. A call option gives you the right to buy the underlying product while a put option gives you the right to sell.

Trading with leverage

Suppose the price of a stock is £20, but you expect an increase in the upcoming month. You can then buy one call option, giving you the right to buy this stock later, at a predetermined price. Say you choose an option that gives you the right to buy 100 stocks, for £21 each, two months from now. To obtain this right you pay a premium, £1,50 for example. This premium must be multiplied by a factor, which is the amount of stocks the option covers, often 100. If you purchase this option contract, the amount you invest would therefore be equal to £150.

If the price of the stock rises to £25 at the end of the 2 months, you can exercise the option, and open a position for 100 stocks at a price of £21 per stock. As the market rate is higher, you could directly obtain a profit by selling the stocks. Per share, you would then receive 25 euros from the sale. Taking the £21 purchase price and £1,50 premium into account, the profit comes down to £2,50 per stock, or £250 total. Had you used the initial investment of £150 to buy the shares directly, you would have got returns over 7 shares instead of 100, and profited less from the increase.

Explanation of options in a graph.

Futures

Another common type of derivative are Future contracts. Futures are standardized contracts which, like options, are made between two parties at a fixed price and expiry date. Unlike options, nearly all futures contracts are settled by cash payments, instead of the physical delivery of the underlying product at expiration. Also, the contract size tends to be bigger when compared to options.

Say you think a stock index will go up. It is currently priced at £600, and you consider a futures contract with a £200 multiplier. The whole value of this futures contract would be £120.000. When trading futures, you do not need to buy the whole amount, but typically put down an initial margin to enter into the contract. Say there is a margin rate of 15%. You would get a £120.000 exposure to the underlying, by making a deposit of at least £18.000 as margin to your account. This means you can get a large exposure for a small initial margin with a futures contract.

Explanation of the contract size and margin required of futures.

Unlike options, futures are settled on a daily basis. This means that if the future has gained 3 points at the end of the trading day, you will receive 3 times the £200 multiplier, for an amount of £600. Do note that because the contract size is bigger than the margin, it is also possible to lose more than your deposit with futures.

Leveraged products

There are also leveraged products which are issued by financial institutions that have varying names and characteristics. With these products you often borrow money from the product issuer in order to trade with increased exposure to an underlying asset and as such create a leverage effect. These products generally bear high cost within them, which are charged by the issuer. Examples of these products are warrants and certificates.

These products, as well as options and futures, are not suitable for the beginning investor because they are complex, volatile by nature, and risky. We’ve only covered the very basics in this lesson, and if you wish to trade these products it is strongly recommended to learn more about them before you start.

Coming up

The next lesson will examine what determines the prices of financial instruments, why they move, and how to differentiate between the different prices.

In addition to the basic financial products covered in the previous lesson, you might have heard of more complex instruments, such as options and leveraged products. These investment products are not suitable for beginning investors because they come with a higher risk of losses. Nevertheless, this lesson will briefly introduce these products so you have a better understanding of the purpose they serve, and the risks that are involved.

Text version

person thinking if the stock will go up or down.

An introduction to derivatives and leveraged products

There is a wide range of financial products to choose from if you start trading, including very complex ones. Examples of these are options and leveraged products. These investment products are not suitable for the beginning investor, because they come with a higher risk of losses. However, we would like to briefly introduce them so that you better understand the risk involved.

Derivatives

If you are the owner of a stock, you also own a corresponding part of that company. But there are also investment products that derive their value from an underlying asset or product, such as a stock or commodity. These products are aptly named: derivatives. Experienced traders can use derivatives to speculate on price movements, or to hedge risk. Although derivatives can in some cases achieve a high return, they typically also come with high costs and risk.

Options

A common example of derivatives is an option contract. If you have a certain expectation about how the price of a stock will change, you can trade on this belief using an option. As the name suggests, options give you the right to buy or sell an underlying asset, like a stock, for a fixed price at a predetermined date in the future. A call option gives you the right to buy the underlying product while a put option gives you the right to sell.

Trading with leverage

Suppose the price of a stock is £20, but you expect an increase in the upcoming month. You can then buy one call option, giving you the right to buy this stock later, at a predetermined price. Say you choose an option that gives you the right to buy 100 stocks, for £21 each, two months from now. To obtain this right you pay a premium, £1,50 for example. This premium must be multiplied by a factor, which is the amount of stocks the option covers, often 100. If you purchase this option contract, the amount you invest would therefore be equal to £150.

If the price of the stock rises to £25 at the end of the 2 months, you can exercise the option, and open a position for 100 stocks at a price of £21 per stock. As the market rate is higher, you could directly obtain a profit by selling the stocks. Per share, you would then receive 25 euros from the sale. Taking the £21 purchase price and £1,50 premium into account, the profit comes down to £2,50 per stock, or £250 total. Had you used the initial investment of £150 to buy the shares directly, you would have got returns over 7 shares instead of 100, and profited less from the increase.

Explanation of options in a graph.

Futures

Another common type of derivative are Future contracts. Futures are standardized contracts which, like options, are made between two parties at a fixed price and expiry date. Unlike options, nearly all futures contracts are settled by cash payments, instead of the physical delivery of the underlying product at expiration. Also, the contract size tends to be bigger when compared to options.

Say you think a stock index will go up. It is currently priced at £600, and you consider a futures contract with a £200 multiplier. The whole value of this futures contract would be £120.000. When trading futures, you do not need to buy the whole amount, but typically put down an initial margin to enter into the contract. Say there is a margin rate of 15%. You would get a £120.000 exposure to the underlying, by making a deposit of at least £18.000 as margin to your account. This means you can get a large exposure for a small initial margin with a futures contract.

Explanation of the contract size and margin required of futures.

Unlike options, futures are settled on a daily basis. This means that if the future has gained 3 points at the end of the trading day, you will receive 3 times the £200 multiplier, for an amount of £600. Do note that because the contract size is bigger than the margin, it is also possible to lose more than your deposit with futures.

Leveraged products

There are also leveraged products which are issued by financial institutions that have varying names and characteristics. With these products you often borrow money from the product issuer in order to trade with increased exposure to an underlying asset and as such create a leverage effect. These products generally bear high cost within them, which are charged by the issuer. Examples of these products are warrants and certificates.

These products, as well as options and futures, are not suitable for the beginning investor because they are complex, volatile by nature, and risky. We’ve only covered the very basics in this lesson, and if you wish to trade these products it is strongly recommended to learn more about them before you start.

Coming up

The next lesson will examine what determines the prices of financial instruments, why they move, and how to differentiate between the different prices.

backtotop

Your investment journey starts here

Open a free account and join over 2.5 million investors worldwide on our user-friendly platform.

Note:
Investing involves risks. You can lose your invested funds. We advise you to only invest in financial products which match your knowledge and experience. This is not investment advice.

Investing places your capital at risk. Read our full warning here.

icon_close

We want to empower people to become the best investors they can be. By offering a universe of possibilities and choices on our user-friendly platform, we are removing barriers to make investing accessible to everyone: beginners or experts. You get access to a wide variety of products on more than 50 global exchanges to have the freedom to invest the way you like. In our world, you also get great value for money. So, without compromising an inch on the quality, security and range of our investment services, we offer incredibly low fees. Prioritising your needs has helped us become the leading European online broker. Our 2.5+ million clients and 100+ international awards are proof of our success.

This communication is issued on behalf of flatexDEGIRO Bank AG and has been approved as a financial promotion on 3rd August 2023, for the purposes of section 21 of the Financial Services Market Act 2000 (FSMA), by Resolution Compliance Limited which is authorised and regulated by the Financial Conduct Authority (FRN:574048). flatexDEGIRO Bank AG is an overseas firm which is not authorised by the Financial Conduct Authority. This means that the FCA Rules made under FSMA for the protection of retail clients do not apply to the services provided by flatexDEGIRO Bank AG but investors are instead protected under applicable German law and Dutch law rules that apply to flatexDEGIRO Bank AG. Investors are not protected by the UK Financial Services Compensation Scheme.

flatexDEGIRO Bank Dutch Branch, a foreign branch of flatexDEGIRO Bank AG | Amstelplein 1, 1096HA Amsterdam | phone: +31 20 261 3072 | e-mail: clients@degiro.com | flatexDEGIRO Bank Dutch Branch is registered with the Dutch Chamber of Commerce under number 82510245. | flatexDEGIRO Bank Dutch Branch, trading under the name DEGIRO, is the Dutch branch of flatexDEGIRO Bank AG. flatexDEGIRO Bank AG is an overseas company primarily supervised by the German financial regulator (BaFin). In the Netherlands, flatexDEGIRO Bank Dutch Branch is registered with DNB and supervised by AFM and DNB. | flatexDEGIRO Bank AG is a licensed German bank supervised by the German financial regulator and registered with the German Chamber of Commerce under number HRB 105687.