Weighing up the options in the stock market

Published in Empower Magazine, July 2009

From options to futures, derivatives to dividends, wealth expert Dale Gillham weighs up the options for investing in the share market.

In my last article we looked at the bigger picture of investing and discussed the three laws of wealth creation. 

Now it’s time to delve into the detail and explain various investment options available in the share market, together the pros and cons of each.

Option 1: Shares

The option to understand is shares themselves (or equities as they are known), which represent part ownership of a company. 

As the part owner of a company you are entitled to a share of the profits by way of receiving a dividend. 

When a company is distributes part of its profits back to the shareholders, the dividend can be expressed by a number of cents per share held.

When talking about shares we often hear the phrase “blue chip” but what are blue chip shares? 

There is no formal definition of what a blue chip share is, however; in essence they are shares in a company that are highly valued. 

These types of companies are known for their ability to generate solid profits in the good times and hold up in the bad. 

Examples of blue chip shares are any of the four major banks. As a general rule of thumb, you could call any of the shares listed in the top 50 for the Australian market “blue chip”.

Benefits

Investing in shares allows you to expose yourself to both capital gains as the shares rise in price, and income in the form of dividends as described above. 

By investing in blue chip shares you know you are investing in the biggest and safest shares in our market that have proven over time to be very good at producing returns for a reasonable level of risk. 

Research I conducted for my bestselling book, “How to beat the managed funds by 20%”, shows that if all you did was buy and hold the top 10 shares for 10 years, your return would be approximately 12 per cent per annum. 

Other benefits are that it is relatively easy and cheap to buy and sell shares as this can be done online, and you are buying an asset that is generally very liquid meaning you can buy and sell freely. 

Lastly, good shares can be used as security to borrow funds for further investment.

Areas of caution

Neither your investment nor your return is guaranteed, so you need to be aware that losses can occur when you purchase shares. 

No share continually rises, therefore when investing in shares you need to expect that they will fall at some time. 

The last 18 months has been evidence of this where many have fallen by 50 per cent, with many smaller shares falling further. 

Given this, anyone using a buy a hold strategy needs to expect that 2 or 3 years out of 10 will see their portfolio will underperform or show negative returns.

Option 2: Derivatives

A derivative is a financial product, known as a “contract”, that derives its value from an underlying asset.

A contract is a legally enforceable agreement between individuals or entities. 

The underlying assets can be such things as shares, currencies, commodities such as wheat, copper, gold or interest rates. 

A derivatives trader is buying or selling contracts, which means they are buying the “right” or becoming “obligated” by selling.

“Derivatives are leveraged instruments, which enables users to control large financial positions in the underlying asset such as shares, indices, currencies or commodities - with smaller amounts of money. 

Derivatives allow a trader to make money in a rising or falling market. 

For example, if you think that a share will rise in price you can purchase a “call option” (one type of derivative) and if you are correct the value of your option will rise as the price as the share rises. 

However, if you think the share will fall in price you would pursue a “put option”, and if you are correct the value of the option will rise as the price of the share falls. 

Buying put options on shares you own is called hedging as it protects you from any downside movements in the price of the share and is like a form of insurance.

Derivatives were developed for the purpose of controlling risk in the financial and commodity markets, very much like the reasons insurance companies developed their business by offering people the opportunity to reduce their risk.

The different types of derivatives are futures, options, warrants, Contracts for Difference, short selling, forward sale agreements, margin foreign exchange and swaps.

While explaining all the above derivatives is beyond the scope of this article, below is a brief outline of the ones you might be more familiar with.

Futures

Futures are standardised exchange traded contracts to buy and sell commodities, securities or other assets on a specific date at a preset price. 

They are legally binding agreements between a buyer and a seller.

Options

Options are standardised contracts between two parties. 

They give the buyer the right, but not the obligation, to buy or sell an asset at a specific time at a predetermined price. 

There can be options over shares, futures contracts and even over property.

There are two types of options:

• Calls – An option the gives the holder the right, but not the obligation to buy the underlying asset at the exercise price at or before a fixed expiry date.
  
• Puts – Options contract giving the holder the right, but not the obligation, to sell the underlying asset at the exercise price.
  

Contracts for Difference

Contracts for Difference or CFDs are relatively new to Australia. 

They are an over-the-counter derivative product without an expiry date where in the contract the parties agree to exchange the difference in the price of the underlying asset. 

Each day, money will be placed into your account or taken from it depending whether the position goes in your favour or not. 

They are traded over commodities, securities, indices or other assets.

The pro’s and cons of derivatives

Another pro is that some derivatives allow limited downside risk such s options, while others have unlimited risk such as futures. 

Other benefits are that some derivatives markets are among the largest traded markets in the world and are therefore highly liquid.

Some of the cons are that often derivatives are complex in nature and are therefore generally only suited to experienced and knowledgeable traders. 

As derivatives expose you to high leverage they generally are not considered a passive investment and therefore can be time consuming to manage.

Given the higher risk nature of derivatives, they are not something those new to the share market should jump at immediately. 

It’s always wise to invest in solid low-risk assets with the bulk of your money and once you have gained the knowledge and experience, then place a small percentage of your capital into leveraged investments such as derivatives.