Getting Started in the Share Market: Lesson 3

/Getting Started in the Share Market: Lesson 3

Trading Instruments

I am constantly asked, “How do you trade options?” or “Do you use CFD’s or futures?” Let me make three points, very strongly, at the outset.

 

  1. Exchange traded options, CFD’s, futures and warrants are all derivatives. They all offer leverage. They were designed for a portfolio manager to hedge his exposure to market risk. Used correctly, the returns can be very high. In keeping with the old market adage, “the higher the risk, the higher the return” these derivatives can be extremely costly to the uneducated. Buyers beware!

 

  1. Investing in the market is a marathon, not a 100-metre dash. Start your investment career by doing the simple things first, buy shares that are rising and make a profit.

When you can constantly make above market average profits in any economic conditions – then, and only then look at harnessing the leverage offered by any of the derivatives.

 

  1. You need to develop a solid trading plan that covers your entry and exits from the market. Once you have generated an entry rule and a particular stock qualifies, you can then decide on whether to buy shares or use an option, warrant or a CFD to take advantage of the anticipated movement. You need to choose the stock first, and then use the trading instrument that best suits your needs.

 

There is a happy band of “experts” constantly running around the country, running $2000 or $3000 weekend courses where you will “learn the secrets of a professional trader”. Unfortunately the vast majority of participants in these courses fail in their trading pursuits.

 

Successful trading can’t be taught in a weekend. Be careful. While the potential profits from trading derivatives are real, the downside is that you are exposing yourself to huge risks. Like anything in life, we must walk before we run. Learn to trade equities successfully before moving on to more elaborate, sophisticated trading instruments.

 

Shares

 

What are Company Shares?

Shares are documents issued by a company to raise finance. A company worth $50 million may want to raise $10 million to fund a project. By doing this it has taken the decision to allow 20% of the company to be owned by members of the public or any other interested purchaser. The company may feel that $1 per share is suitable and therefore will make 10 million shares available for buyers. By buying a share you become a part owner of that company. Anyone can buy shares in a publicly listed company.

Dividends & Share Price

Earnings from shares are two-fold:

 

  1. The value of the share can rise when the performance of the company involved is trading well, subject to a takeover, or may be on the verge of a “new” discovery.

 

  1. A company may choose to pay a dividend. Payment of a dividend in the past is no guarantee of dividend payments in the future.

Aim for capital growth: there is no point receiving a dividend if the share price has halved. A dividend should be treated as a bonus that you receive for owning the right stock at the right time.

 

Contributing shares

Another instrument is the contributing share, which is similar to an option in terms of leverage potential, but will involve the requirement of holders to pay incremental payments to continue to hold the right to convert it to a fully paid share. Many are issued at a low entry price, and may involve a number of small payments over time, before a final predetermined amount is paid to fully convert it into a fully paid share.

 

Stock options

When companies look at raising fresh capital a number of choices are available. One choice is the listed company option. Listed company options are normally issued at a minimal cost to shareholders and investors as an incentive to participate in a placement of fully paid shares.

This option gives the buyer the right, but not the obligation to convert their option into a fully paid share at a future date, which is pre-determined when the option is issued.

The main features of a listed company option include:

  • The underlying security.
  • The exercise price.
  • The exercise date.

American options provide the holder with the opportunity to convert their option into a fully paid share at an anytime up until expiry, whilst European options can only be exercised at expiry. Both European and American options are actively traded on the ASX and their role as an investment tool is gaining a wider acceptance.

ETF’s

https://www.moneysmart.gov.au/investing/managed-funds/exchange-traded-funds-etfs

What is an ETF?

An ETF is a type of investment fund that can be bought and sold on a securities exchange market. In Australia, ordinary ETFs are ‘passive’ investments that track an asset or market index (for example, the ASX200 Australian share index). They generally do not try to outperform the market and will go up or down in value in line with the index they are tracking.

If an investment is called an active ETF then the fund manager is actively trying to outperform the market or index to achieve a different investment objective. See other exchange traded products for information on active ETFs.

The difference between physical and synthetic ETFs

ETFs are available for a broad range of assets including Australian shares, international shares, fixed income products, foreign currencies, precious metals and commodities. They can be used as a way to diversify your investment portfolio, and usually have lower fees than a traditional managed fund.

Physical ETFs

Standard or ‘physical ETFs’ buy the underlying investments (such as shares and other assets) on the reference index that the ETF is seeking to track.

If you invest in an ETF, you won’t directly own the underlying investments, the ETF will own these, you will own units or shares in the ETF.

Your main investment risk is the performance of the underlying shares or other assets. Other risks are discussed below.

Synthetic ETFs

Synthetic ETFs have a material exposure to derivatives as well as the underlying assets that the ETF is seeking to track. Along with the benefits and risks of physical ETFs, synthetic ETFs have additional risks such as the credit risk associated with the derivative counterparty. Find out more about synthetic ETFs.