The DOTS: episode 4
While factor certificates are considered to be among the riskiest financial instruments, they are also a favourite of traders looking to trade on a daily basis and seeking thrills and yield.
The Swissquote DOTS universe clearly contains a variety of financial products. Previous articles have covered warrants (and knock-out warrants) as well as mini-futures. Some of these instruments are relatively complex (such as warrants), while others are simple (such as mini-futures). Factor certificates are a subtle combination of both.
Calculating the value of factor certificates is easier than for warrants. Time value has no relevance, as they have no maturity date and volatility is not factored into the calculation. In this sense, these products are more like mini-futures. But they also differ from mini-futures in the way their price fluctuates.
What are factor certificates?
They are instruments that allow their holder to take disproportionate long or short positions in the price of an underlying (equity, index, commodity or currency). Why? Because they have a constant leverage factor.
In other words, they multiply the percentage gain or loss in the price of the underlying assets by a contractually defined factor: the leverage. Unlike warrants and their knock-out cousins, this leverage effect is not variable but constant. Issuers offer certificates with leverage ratios that can be higher than ten.
As a general rule, these certificates have an unlimited term. The issuer may, however, terminate them with one day’s notice.
Calculating the price of a certificate
When the product is issued, the reference price of the underlying is used as the basis for calculating the performance and therefore determines the contract’s value.
When the closing price is reached, the performance of the underlying is calculated and the price of the certificate is displayed. These prices will be used as a reference when the markets open the following day.
Formula for a Long factor certificate
Current value of the certificate = Previous day’s value x (1 + the leverage factor x the current performance of the underlying) − the current value of the financing
Formula for a Short factor certificate
Current value of the certificate = Previous day’s value x (1 − the leverage factor x the current performance of the underlying) − the current value of the financing
In the event of sharp fluctuations in prices during a given day, the issuer may recalculate its product by adjusting certain valuation levels.
What is the upside of factor certificates?
Thanks to leverage, investors may participate disproportionately in the performance of the underlying asset. But for that to happen, the price of the underlying clearly has to keep moving in the expected direction. Where the reverse happens, the opposite will occur, i.e. a disproportionate loss.
This is why most investors do not hang on to these products for long. For most traders, one day is enough. Note that the longer they are held, the likelier it is that the price of the underlying will not behave in the expected manner. Paradoxically, a total loss on the investment may occur even if the price of the underlying eventually moves in the right direction. Why? Because the certificate is revalued every day. That is why people refer to path dependency or, in other words, historic trajectory.
Path dependency
This is definitely the most important aspect for someone interested in factor certificates. An example is more useful than a long theoretical dissertation.
In this case, the price of the underlying fluctuates little but, above all, does not show any clear trend (flat path dependency). As a result, the value of the certificates falls, more or less severely depending on the leverage, and may even fall to 0 after 15 days.
The documentation produced by the issuers on the DOTS platform describes three types of scenario:
1) A constant and stable upward trend
2) A constant and stable downward trend
3) Irregular trend with prices that rise and fall
The third scenario is a good illustration of the fact that holding a certificate for more than one day constitutes a relatively risky bet, unless the trend (path dependency) is clear (either up or down). Attention therefore needs to be paid to the choice of certificate and its leverage.
What areas should investors pay attention to?
Potential investors should understand that factor certificates are only suitable for very short-term speculation, and not as long-term investments. The longer they are held, the greater the risk that the investment’s trend will change. Added to the multiplier effect provided by leverage, the consequences on the prices of certificates are considerable.
But that takes nothing away from the appeal of this type of product for seasoned speculators looking for substantial quick yields.
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All investments carry a degree of risk.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74–89 % of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
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