Every morning we hear the ASX is set to open higher or lower, but how do they know? Derivatives are usually involved.

Derivatives are assets purely based on the value of other assets, but are usually valueless in their own right.

They can track things like the debt market, the All Ordinaries, and commodities — and can also give companies a handy option when raising cash.

In short, they’re contracts between two parties which are essentially bets about whether an asset price may go up or down in the future.

Still a bit confused? That’s okay — we’ve got a few examples below.

Can you see into the future?

 

Futures are a unique type of derivative.

Futures are based on underlying values of financial assets, most particularly equity market indices and commodities.

Holders of futures are obligated to transact in certain underlying assets at predetermined prices on a set date.

An example

One holder (Holder X) may think the ASX will go down by the end of tomorrow’s trade, and one (Holder Y) may think it will go up.

So, those two parties get together and agree a price to trade (Holder X to Holder Y) at at the end of trading.

That price will be above what Holder X thinks it will be, but below what Holder Y think it will be.

If the price ends up going above the settlement price, Holder X will be able to sell to Holder Y at a premium.

Good for Holder X.

If the price goes down below the settlement price, Holder Y will pick up a bargain.

How this works for the ASX

Thousands upon thousands of similar bets are made each day between the time the ASX closes, and the time it opens the next day.

Traders will take data from the happenings between trading sessions to place their bets.

If there’s positive economic news out of the US for example, they will price that into their bets.

Therefore the average settlement price overnight becomes an indicator of the way traders think the market will turn the next day.

So when you hear a prediction in the media about how the ASX may go on any particular day,  either they’re taking their cue from major markets such as the US market, or they’re looking at the SPI futures and how they settled overnight.

If the average settling price of the futures is above that of the ASX200 on the previous day, then they have a general idea that the market may trade up.

But futures that trade an index of equities aren’t the only type of futures that can be traded.  

Other options?

 

The ASX also has other derivatives. These fall into three main types: energy, agricultural and interest rates.

There are only five agricultural derivatives, two wheat derivatives as well as barley, sorghum and canola.

Although at face value, these are traded as if you are buying the commodity itself, usually only agricultural firms will take delivery of the asset rather than just trade futures.

Energy derivatives work in a similar way although these mainly relate to electricity prices in Australia and New Zealand, except for one unique derivative for Victorian wholesale Gas. Electricity companies.

The latter category has options in relation to the Reserve Banks’ cash rate as well as government bonds of both Australia and New Zealand.

One interest rate derivative, the ASX’s 90 day bank accepted futures bill, is in the top 10 most traded interest rate futures contracts by turnover.

All these work similar to ASX futures, in that traders will adjust their positions based on current events and speculation about the future direction of prices.

Derivatives can also give companies a helping hand when it comes to raising cash or incentivising directors.

What are my options?

 

Options give holders a right, but not an obligation to trade a specific asset, such as shares. It is common for newly listed companies to give options to shareholders and to its management.

These often have an expiry date, and the implicit hope is that the share price will be several times higher than the exercise price, in which case the options holders will make a substantial profit.

An example

One instance is Xanadu Mining’s (ASX: XAM) placement in June last year.

The Placement was conducted at 17 cents per share and raised $10 million.

Investors received one option for every two shares purchase in the Placement which would expire 2 years afterward and have a strike price of 25 cents.

That extra option swayed several shareholders to take place in the offer. They were willing to bet that the company’s share price would be above 25 cents in 2 years’ time.

Therefore options become a quasi-derivatives trade against the future value of those shares. If it’s above 25 cents on the strike date, shareholders can pick up a bargain.

 

This content does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.