Understanding derivatives trading (Post 1): The basics
In this short series of blog posts we will provide an introduction to derivatives and the associated market structures. We will briefly touch on the ongoing reforms on OTC derivatives markets, and conclude by providing a few observations about the expanding blockchain-based derivatives markets.
What is trading?
While modern electronic trading may seem like an obscure and overwhelming activity (user interfaces full of flashing green and red lights, graphs with candlesticks and all sort of tools for technical analysis etc.) with sophisticated pre-trade operations (e.g. modelling/simulations, market analysis, technical analysis etc.), trading is in reality a very simple concept. Trading simply consists in “agreeing” (i.e. “shaking hands”/“signing contracts”, see Fig 1 below) and “exchanging” (i.e. deliver on the terms of the contract).
Nothing more.
In lots of contexts (e.g. buy a house, buy a financial product) the agreement must be embodied by a written contract signed by both parties, as per the statute of frauds (see also here).
(Note: we will focus on bilateral agreements here, for simplicity).
As soon as the two parties agree on the terms of the trade, they execute the contract (i.e. they both sign the agreed contract), after which its terms become legally binding (see e.g. English contract law) on the parties to the contract¹.
In less formal contexts (e.g. when negotiating the price of tomatoes in a local market), the agreement is often articulated and sealed orally or by “shaking hands”. Such forms of non-written agreements are harder to enforce, however, and generally rely on trust and reputation.
All in all, everyone trades in their day-to-day lives without even thinking about it. If you have ever purchased something, you have been involved in a trade. Trading is part of who we are. We are all traders.
The importance of risk management
We saw that trading is all about creating and signing contracts, and exchanging (as per the terms of the contract). Moreover, we saw that a contract is executed as soon as all parties have signed the agreement, point after which the contract becomes legally binding under contract law.
But, what if the contract contains ambiguous terms that can be turned against you? What if the contract counterparty cannot fulfill his/her duty as agreed? What if the market moves against you, making your trade not profitable? and more generally: What if your environment evolves in a way that wasn’t expected and exposes you to financial harm or loss?
For sure, trading comes with some risks of its own (the mere fact of signing contracts comports risks²; and even if a great deal of effort and money is allocated to design unambiguous and comprehensive contracts — see e.g. here for guidelines— removing a source of “intrinsic contract risk”, the risk of breaches of contract by the counterparty persists. By syllogism, these risks also apply to trading³). Furthermore, each traded asset induces different types of risks that are market specific.
However, risks simply are everywhere. We all live in a complex and risky world that we simply cannot control. Life is about facing risks on a day-to-day and the current state of the world provides a myriad of examples of risks affecting society at large (e.g. threats of climate change, Covid19 pandemic, various deterioration in international relations etc.).
Of course, accepting the status quo would be very unsatisfactory. Accepting to bear more and more risks on one’s shoulders provides a rather pessimistic outlook for the evolution of society.
Rather, we shall constantly ask ourselves: how can we live while minimizing the risks we all bear on our shoulders? Can we design risk-management tools that would empower people with a way to get rid of some of the risks they are facing?
The answer is “Yes”. Welcome to the realm of derivatives.
Derivatives
A derivative is a contract between two or more parties which derives its price from an underlying (group of) asset(s).
Example (Options)
An option is a (derivative) contract between two parties that grants one party the right, but not the obligation, to purchase a specified amount of an asset from (in this case we talk about a “call option”), or sell a specified amount of an asset to (in this case we talk about a “put option”) the other party, at a specified price (called the exercise price) before a specified expiration date. Sticking to our contract-centric mental model for the sake of this example, buying an option can be seen as buying a contract, signed by the option issuer, that states that the option issuer will either sell (call options) or buy (put options) the underlying (e.g. oranges, wheat, shares of a stock) to the option holder for a given price and at a given point in time, if the holder decides to exercise the option at (or before — for American-style options) the expiration date.
If we see an option contract as a bilateral contract between issuer and holder, it then requires two signatures to be executed. The contract holder (option buyer) can decide to either sign the contract and thus execute it for the specified exchange to happen, or simply decide to throw the contract away (i.e. not execute it).
All in all, buying an option is effectively buying a right — which is formalized as a set of contract terms. If this right is exercised, the issuer has the legal obligation to follow the contract terms and either buy or sell the underlying as per the terms of the contract.
There exist two main categories of options: physical delivery and cash-settled options. Many different flavors exist within these two main categories. See e.g. here for more information about standardized options.
Other examples of derivatives contracts are: Futures, Forwards, Swaps among others.
While trading the right to buy something at a given price and given date may sound like a somewhat obscure and exotic practice of modern finance, it is rather all the contrary. It is very natural and a fundamental pillar of a well functioning economy. The value of trading derivatives contracts has been recognized for millennia. While it is believed that the first derivatives trades happened in Sumer, a region of southern Mesopotamia — where people exchanged and recorded clay tokens in a way that resembles today’s futures contracts — , the first recorded trade that greatly echoes today’s options trading appears in Aristotle’s Politics, Book 1 in which he recounts a trade made by the philosopher Thales of Miletus⁴.
So, while inflammatory headlines about derivatives tend to be the norm rather than the exception, blaming these instruments for being the cause of the Great Financial Crisis of 2008/2009 (see e.g. here), increasing speculation on financial markets etc., it is worth taking a step back and rather expose how risk-management tools like derivatives can greatly benefit society. Like any instrument, derivatives can indeed cause “mass destruction”⁵ if used in excess and incorrectly (more details on that later).
Social purpose of derivative contracts
The purpose of equity markets is rather clear. There are the mediums through which companies can access to capital. To that end, companies issue and sell shares of their business, that investors acquire. By purchasing shares, investors allow companies to grow their business (invest in new production sites, hire more people etc.), while hoping to realize gains on their investment.
As we have seen above, trading is intrinsically risky (but necessary). Trades happen within an ever changing environment that cannot be controlled by trading counterparties. So if equity markets fulfill an essential role for capital allocation, essentially fueling the growth of an economy, derivatives markets fulfill the equally as essential role to protect the newly allocated capital. Derivatives are effective risk reducing tools that prevent capital erosion and provide stability.
Example
A beetroot farmer can use a derivative contract (e.g. a beetroot put option) to lock in the price of beetroot (which may fall between now and the next harvest due to — among others — unpredictable climate conditions) in order to remove risks of fluctuating prices and operate within a more stable environment. Likewise, airline companies can use derivative contracts (e.g. oil call options) to lock in the price of oil and protect themselves from disruptive OPEC decisions, effectively bringing stability to their business.
Speculation
The attentive reader will realize that there is a missing piece to this “derivative as risk mitigation tool” puzzle. A derivative contract is a not unilateral, so, for the farmer or the airline company CFO to get rid of some of their risks, someone else must be willing to take the other side of the trade (i.e. they need a counterparty to their contracts)!
This is where “speculators” jump in. Often talked about as “the plague of financial markets” in the headlines, speculators are risk taking actors in search of making profits from subjective predictions of price movements (like Thales of Miletus in our example above!).
Not to be mistaken with “gambling”, speculative behavior is not necessarily related to an attraction for risk itself or an attraction for a sense of play (like a “risk-addict” or gambler would). Rather, speculators use their knowledge to form an opinion about price movements, and by doing so, help making sure that prices reflect underlying fundamental values.
In effect, risk averse actors (like our beetroot farmer or our airline CFO above) and speculators are opposite poles of a magnet and attract each others, effectively allowing risk averse actors to offload/transfer their risks onto the shoulders of the speculators who hope to cash in some profits.
The profits that speculators earn are, in essence, the compensation for the work they did in collecting information about the traded asset and providing it to the market, as well as the risk taken by entering the position (the speculator’s opinion about price movement can turn out to be wrong).
Such risk transfers create new economic opportunities and — above all — provide stability to businesses which can better protect their capital and plan ahead (certainty and stability is crucial for a business).
Takeaway
Trading derivative contracts and speculating are two sides of the same coin. Often seen negatively, they fulfill an essential role by providing people with a way to get rid of their risks, essentially protecting their capital and diminishing business uncertainty. The notion of “derivatives” is very broad and doesn’t constraint the terms of the contract. As such, derivatives can be used to trade any underlying asset (without the burden of holding it) in any market condition (bull/bear market).
Leverage
Leverage is an important concept in trading. In essence, leverage trading is a mechanism by which investors can increase their exposure to the market while paying less than the full amount of the investment (leverage amplifies one’s gains as well as one’s losses). In other words, leverage provides a way for investors to achieve more with their capital. Hence improving capital efficiency.
Leverage can be seen as a ratio DEBT(or, size of a portfolio):CAPITAL (e.g. 25:1, which means that for $1 of capital, you “control” $25). As such, it is easy to see how to “manipulate” leverage. To increase leverage, increase debt and/or decrease capital. To decrease leverage (i.e. “deleverage”), decrease debt and/or increase capital.
Leverage can be achieved in two ways:
- By “borrowing money to trade” (i.e. balance sheet leverage), or
- via off-balance-sheet transactions (e.g. derivatives trades)
Balance sheet leverage is rather straightforward and reduces to outright borrowing (e.g. borrow a given security to trade it, borrow cash to trade etc.). The strategy becomes viable when the expected returns outweigh the interest on the loan and the fees to open a position.
Leverage trading via derivatives relies on the notion of Notional Value. The notional value is the total underlying amount of a derivative trade. Looking at futures contracts for instance (e.g. crude oil futures or S&P 500 futures), we see that each contract has a standardized size/multiplier representing the “amount of underlying for each derivative contract” (it is denoted as “Contract Unit” in the examples linked above). As such, the notional value is computed as: Notional Value = Contract Size * Underlying Price. As explained here, buying such contracts necessitates a small capital outlay (much smaller than the notional amount) while allowing the trader to earn the return on the notional amount of the contract!
Example
Assuming the price of a barrel of crude oil is $70, then buying one contract of crude oil futures allows you to control: 1000 * 70 = $70,000 on this market. As such, with the small amount of capital necessary to buy the contract, you can earn a return on $70,000.
“Like any instrument, derivatives can indeed cause “mass destruction”⁵ if used in excess and incorrectly (more details on that later).”
Remember when we said that derivatives could cause trouble earlier in this post?
Well… one way in which “derivatives can go wrong” is when traders are over leveraged (note that, over-leveraging can also happen in other markets!). In fact, we know that, for a given trading strategy, there exists an optimal leverage level above which the trader is almost certain to lose capital in the long run — see e.g. Kelly Criterion that describes the theoretical boundary of rational bets, above which risk is increased and profits decrease over time.
However, the nature of the derivatives traders dictates the seriousness of the issue. While over-leveraged retail derivatives traders is unfortunate and can put such traders in difficult financial situations (effectively begging for more consumer/retail protection and financial education by financial watchdogs in various jurisdictions), such scenario does not constitute “mass destruction” per say. The real issue is when systematically important financial institutions engage is such type of trading, effectively increasing sources of systemic risks (more on that in the next blog post of this series).
All in all, and coming back to the notion of leverage: too much leverage is bad (increases risks of default), but reasonable borrowing/leverage is a necessity for a well functioning economy. For instance, without efficient means of borrowing for our day-to-day trades, few people would be able to afford a house for instance⁶. Refusing to use leverage means that transactions require large capital outlays which is very inefficient and restricts people to the trades they have sufficient capital for.
In what follows, we will refer to leverage in the context of trading derivatives.
Margins
As we saw, trading derivatives allows to gain exposure to the notional value of the contracts, with limited capital outlay. This initial capital — required to enter in a derivatives trade — is called the initial margin.
Initial Margin (IM)
To trade on margin (i.e. to do leveraged trading), one must first deposit an “Initial Margin”. The IM is the amount of collateral/capital to deposit in an account called the margin account to “control a derivative contract” (e.g. for a 30% initial margin requirement, you must put £300 as collateral/initial margin in your margin account to be able to open a position of £1,000).
Maintenance Margin
Once the position opened, the margin trader is highly exposed to the market and the balance of the margin account fluctuates according to the changes in the contract price (which is derived from the price of the underlying). Gains are magnified, but losses are exacerbated. So, in order to keep the system solvent and limit counterparty risk (i.e. limit “default risk” here), the traders are required to keep the amount of their margin accounts above a certain threshold: the maintenance margin requirement. This threshold represents the amount of margin (i.e. the amount of cash, or highly liquid securities accepted as collateral) that must be deposited to the margin account in order to maintain the position opened (this amount is below the IM).
If the balance of the margin account decreases towards the “maintenance margin requirement”, the trader receives a margin call from the margin account operator (e.g. the broker). Roughly speaking a margin call can be translated in plain English as the following warning: “you are loosing too much money, put more capital in the account, or we will close your position!”. In other words, the market moves against the trader who now needs to increase the capital in his margin account (and thus decrease the leverage ratio) to maintain his position opened.
If the balance of the margin account decreases below the maintenance margin requirement and reaches the liquidation level, then the position is liquidated. This can happen, for instance, when the trader didn’t have time to deposit more collateral in the margin account in the event of highly volatile markets. In plain English, this translates into the following message from the margin account operator: “you lost too much money, this was unsafe to keep your position opened because you could have defaulted. As such, we closed your position while you could still pay what you owed to the winning side of the market”.
It is important to remember that each trade is a bilateral contract. As such, if one party loses a lot of money, the counterparty wins a lot of money (the “losing side of the market pays the winning side”). Margining is here to make sure that the winning side of the trade always get paid (i.e. prevent counterparty default).
Clearing
We started this blog post by defining trading as a 2-step process: execution and settlement.
We stated that a “trade” was the creation and execution of a contract with a counterparty. Nevertheless, while talking about “leveraged trading”, we started to see how this definition was unsatisfactory and incomplete.
It is worth bearing in mind that the essential purpose of the contract relationship is: exchange. The very essence of a contract is a reciprocal relationship in which each party gives up something to get something. If “exchange” does not happen (e.g. because a party defaults), the purpose of the contract needs to be questioned!
As such, it is more accurate to define “trading” as a 3-step process where an extra step — Clearing — seats between the execution and the settlement.
We summarize the “trading” lifecycle below:
- Execution: Agreeing, signing the contract/“shaking hands”
- Clearing: Intermediate steps to “keep the contract active and arrange for the transfer of money and securities’’. Steps carried out to make sure the contract settlement will happen successfully
- Settlement: Enforcement of the contract, both parties meet their obligations, “cash changes hands”
Recap’
In this blog post we saw that:
- Trading is all about executing (i.e. signing) contracts and exchanging goods or services as per the legally binding terms of the contract.
- Trading is essential but it comports risks.
- Risks can be transferred using derivative contracts.
- Margin trading allows for better capital efficiency.
- The margin management process exists to make sure that the system remains solvent and that losing positions are liquidated on-time or “topped up” with additional margin to remain opened (effectively deleveraging the position).
In the next post, we will dive into the two families of derivative contracts: Exchange Traded Derivatives (ETDs) and Over-the-Counter (OTC) derivatives. We will discuss about the structure of these products and see how they induce specific market structures. We will discuss some of the reforms in OTC markets, and conclude by providing a few observations about the emerging field of decentralized derivatives.
Footnotes
[1]: This is well defined under English law for instance, where “simple contracts” and “deeds” are 2 forms of written agreements, see, e.g. here for more information.
[2]: We note that lots of risks associated to “smart-contracts” are similar to the risks of “paper” contracts (e.g. risks due to opaque contract language/intrinsic risk/complex contract content etc.).
[3]: “Signing contracts carries risks. Trading consists in signing contracts and exchanging, as per the terms of the contracts. Therefore, trading carries risks”.
[4]: The quote of interest is the following:
Thales, so the story goes, because of his poverty was taunted with the uselessness of philosophy; but from his knowledge of astronomy he had observed while it was still winter that there was going to be a large crop of olives, so he raised a small sum of money and paid round deposits for the whole of the olive-presses in Miletus and Chios, which he hired at a low rent as nobody was running him up; and when the season arrived, there was a sudden demand for a number of presses at the same time, and by letting them out on what terms he liked he realized a large sum of money, so proving that it is easy for philosophers to be rich if they choose, but this is not what they care about.
In other words, Thales of Miletus effectively paid a small down-payment to secure the use of the presses (i.e. paid the premium of an option) when demand was low, and cashed in during peak season (exercised the option and cashed some profit by operating his olive presses himself or selling the capacity to someone who was willing to operate them).
[5]: In reference to Warren Buffet’s famous statement:
In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
in Berkshire Hathaway Inc. 2002 Annual Report.
[6]: If you bought your house 15 years ago for £200,000 with a deposit of £20,000 and £180,000 of borrowed money, and have just sold it today for £350,000, you did a leveraged trade. You increased your exposure to the market by borrowing money, and generated a profit after selling your house (assuming low mortgage interests). Such gains wouldn’t have been achievable without borrowed funds.
Acknowledgements
Thanks to Robert Sams for providing feedback and suggestions on a previous version of this post.
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