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Lesson 6
Other Markets
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(To obtain this as a PDF document click here)
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Most of the discussions in the preceding 5 lessons have dealt with investing in the Share Market. However, there are a number of other markets available that investors can invest or trade in. The Technical Analysis methods we have discussed will apply equally to these markets. These markets are also affected by changes in the Economic and political environment.
Closely aligned to the Share Market are the Futures and the Warrants Markets. Both of these markets allow you to buy and then trade the right to purchase a share at a set price on a given date in the future. Both of these markets are easily available to the small or large investor alike. Your existing Stock Broker will be able to facilitate deals in these markets for you.
The Gilts or Bond market is traditionally used by larger and institutional investors as even the smallest deal you may make will probably amount to tens of thousand of rand. The amount of money that changes hands in this market each day by far exceeds that dealt in the share market with most deals running into multiple millions of rand.
The Commodity Market is tied in with the basic items of the economy and where an industrialist would purchase his iron ore from, a mill its grain, a large food distributer its fresh fruit, and so forth.
In each of the above markets, in addition to purchasing the actual item under discussion, you could purchase and trade the “Option” to buy the item (i.e. entering into the contract does not force you to take delivery of the item). People who use this means to trade are often referred to as being in the “Options Market”.
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| Gilts or Bonds |
The ‘Gilt Market’ derives its name from the term ‘gilt-edged security’. A security was deemed to be ‘gilt edged’, or in other words lined with gold because the government issued them. The exact nature of a gilt is that it is title to a loan made to the government or other public sector borrower such as Eskom, Transnet, Telkom, Umgeni Water Board, one of the larger Municipalities, etc. which will receive a fixed rate of interest on the nominal value of the loan until such time as the loan is redeemed. This title is represented by a certificate.
Usually, an investor would invest in Gilts to obtain a fixed interest income. Capital growth is also possible through this medium, but as such needs to be done through ‘margins’ and is highly ‘geared’, it is much more risky than the general stock or equities market.
The Bond Market exists primarily to help the issuers of the securities to raise the capital they require. In theory what is borrowed is used to finance capital projects, such as power stations, developing new suburbs, etc. which then develop an income stream to finance the interest payments and amortise the capital - in other words to pay back the loan. In practice the Government uses the Bond Market to fund the deficit between income and expenditure - known as the Budget Deficit.
Normally these loans are made in units of 1 Million Rand (known as the contact size) and they are then traded in lots of 10. It thus immediately becomes apparent that this is a market for the “bigger” investor! However, many brokers will split up a contract amongst a number of smaller inventors, and so the private investor could buy a share of one (probably in the tens of thousands of rand). As such, you do not hold the certificate and are reliant on the brokers long term existence/integrity.
Interest on Gilts are paid quarterly.
In the Bond Market, because the interest payable on a gilt is fixed, the capital amount varies in line with the general movement in interest rates. Rising interest rates means falling capital values.
For example, when the general level of interest rates are 10%, a fixed interest security acquired for R10 000 would pay a return of R1 000 giving a yield of 10%. If you invest R10 000 in such a Bond, you get a certificate entitling you to R1 000 per annum and the guarantee that at the end of the investment period your capital investment, namely R10 000 is paid back to you. During the period of the investment, you can sell this certificate to someone else. Ownership is transferred to them. From now on, they get the interest, and if they in turn do not sell it to someone else, at the end of the investment period, they get the original capital paid back to them. If interest rates remain at about 10%, you could sell this Bond to someone else for about R10 000.
If interest rates go up, why would you buy a bond that is paying 10% when you can get 12% or 15% somewhere else (like at your local bank?). Bottom line is that you would not. The only way you would invest in that Bond is if you were to get a competitive return on your investment. Since the interest rate is fixed (for the entire time to maturity that bond pays only 10%), the only variable is how much you then invest. Consider the following:
If the general level of interest rates rises to 15% this self same fixed interest security continues to pay R1 000 per annum. A prospective buyer would only be prepared to invest R6 667 because this is the level at which the R1 000 income per annum gives a 15% return (R1 000 is 15% of R6 667). The calculation to determine the capital value of the fixed interest security is:
R10 000 X 10% ÷ 15% X 100% = R10 000 X 66,67% = R6 667
This is the price at which a fixed interest security, with a nominal value of R10 000 paying 10% per annum (ie. R1 000), yields 15% in line with current market conditions. In reality the new buyer may pay a bit more than this dependent on how long the Bond still has to run since upon maturity he will be paid back R10 000 by the original issuer of the Bond.
If Interest rates were to drop to 8%, you could then sell a R10 000 Bond for about R12 500 as this represents the capital investment at current interest rates to obtain a yearly interest payment of R1 000.
So in the bond market, rising interest rates reduces the capital value of the bond, and this is therefore a bear market. Falling interest rates represent a bull market.
Hence, as interest rates change, so does the capital value of the bond. If the general level of interest rates then rises to 18%, this bond would continue to pay only R1 000 per annum - the capital value of the bond would fall to R5 555, since this is the level at which the R1 000 gives a return of 18%.
The concept of interest paid on interest becomes important when calculating ‘yield to maturity’, that is, the overall yield on any fixed interest security is made by taking the capital paid for the security, the simple rate of interest (being the amount of interest per annum divided by the capital paid, multiplied by 100) and calculating the value of the interest that would be earned on the interest as and when it is paid and taking into account any premium or discount on redemption and expressing the total return as a percentage of the capital paid for the security.
The concept ‘term’ is also important when discussing yield or return. Just as a simple savings account usually pays a lower rate of interest than a 1 year deposit, so in the Bond Market ‘term’ varies from less than a year to 30 years and the rates vary widely. A thirty-year term security gives the highest return and those with a term of a year or less pay the lowest return. As term shortens, the yield on a given security declines, thereby increasing its capital value.
The standard transaction unit in the Bond Market is a nominal value of R1 million. This is obviously beyond the reach of most private investors, but smaller investors can participate in the gilt options and futures markets. Because the cost of participating in the bond market is so high, it is mainly institutions that buy and sell these instruments.
(click image to enlargen)
The bond market must compete with the money market, the equity market, and any other market which aims to attract new investment. Its rates therefore tend to rise and fall in line with the general pattern of long term interest rates in the economy. This can be seen from the above graph of the Prime Interest Rate in South Africa from the late 1990's to 2023 (rate rose from 20.25% in 1997 to a high of 25.5% in late 1998 and back down to under 8% by 2005). Also shown is the net yield of the Government’s 30 year bond, called the R186 which provides 10.5% interest and matures in 2026.
The purpose, from an investors point, of using the bond market would be firstly to provide a fixed income (guaranteed for the term of the contract which could be up to 30 years!) and secondly, if interest rates are volatile and the investor correctly guesses which way they will go, a reasonable capital growth.
(click image to enlargen)
Take as an example the R186 shown here. If you had bought this Bond at the beginning of October, you would have been able to sell your bond for about 16% more than you paid for it in the first week of January. This was in anticipation of general interest rates which were rising the entire preceding year may stabilise or fall. However, as interest rates continued to rise, from February the capital value of your bond fell some 26% to its lowest level in May. In August, you could have sold it for some 12% more than you paid for it in mid-May. This would have been in addition to the 10.5% of interest you would have obtained!
Gilt contracts in South Africa are usually traded in contracts of R1 000 000 (one million ZAR - UK Gilts are usually in GBP100 000 lot sizes - USA vary from USD100 000 to USD1 000 000) and even when bought on margin (high risk) can be out of the reach of all but the very large private investor. If you do not purchase the gilt on margin, but pay for it in full, certain dealers may split a single contract amongst a number of investors. Such “part-contracts” are not that readily available and are usually multiple tens of thousands of rand each.
The normal investor who wishes to enter this market, usually is able to do so via a unit trust gilt fund. These provide the fixed interest and buffer the owner from the major fluctuation of the capital amount. Unfortunately the unit trust investor cannot decide which way he thinks the interest rates are going and benefit accordingly. He is at the mercy of the fund manager who makes that decision.
As mentioned earlier, the smaller investor can approach his broker who may be able to sell him a part share in a Bond. The capital growth/loss and interest paid will all be the same as if you had purchased an entire R1 000 000 contract.
There is a further method by which speculators can enter the Bond market, namely buying on margin. You do not physically purchase an entire 10 contracts, but rather put down just a “small” deposit, called a margin (R25 000 to R50 000 per contract!) against that purchase. Since a 1% move in interest rates can affect a Bonds capital value by some 5 to 10% (i.e. R50 000 to R100 000 on a R1 Million contract) your margin can either double or get wiped out very quickly. The concepts are similar to the gearing or leverage discussed in the next section on futures.
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| Futures |
The concept underlying the futures market will be explained using commodities for illustrative purposes.
A futures contract is an agreement to buy from, or sell to, a futures exchange a standard quantity and quality of a specified asset. This asset could be either a commodity (eg. maize), or a financial (eg. the E168 long bond) or a notional asset (eg. The All Share Index - ALSI). It is a deal entered into now, but effected at a future date. In South Africa, futures trading is controlled by the South African Futures Trading Exchange (SAFEX)
Commodities are raw materials in use every day - oil for petrol, wheat for bread, rubber for tyres, gold for jewellery, etc. There are also many businesses which buy and sell these commodities on the cash or spot market (so called because the cash price is paid ‘on the spot’).
Businesses dealing in commodities on the cash market must, of necessity, scrutinize current events very carefully in an attempt to identify future price trends, since commodity prices, like share prices, are determined by supply and demand. If a commodity is plentiful compared with demand, its price will be low: conversely, if scarce its price will rise. The supply and demand may vary on a seasonal basis, for example, the price of wheat would normally be lower during the harvest season when supplies are plentiful. Similarly, jewellers often lay in stocks of gold and silver for the holiday season around September, which should see a rise in the gold price at that time, other variables affecting this price being equal.
The origin of the futures market was to help businesses reduce risks. For example, as a farmer planting a potato crop you are at the mercy of disruptive forces which can influence supply and demand, in the form of weather, labour disputes, political turmoil, changing public tastes and pests. These factors make it extremely difficult for farmers to estimate the quantity and type of crop to plant. Similarly, manufacturers might take advance orders for goods at a given price, only to find that when they come to buy the raw materials the prices are higher than anticipated.
Thus a futures contract is:
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An agreement to buy or sell |
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a standard quantity and type |
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of a commodity or a financial asset or a notional asset |
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on a specified future date (ie. delivery date) |
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at a price determined at the time of entering into the contract. |
Buyer and seller are required to put down a good-faith deposit (margin) to ensure that neither will renege on the deal. This is paid to the broker.
With a futures contract, the farmer or manufacturer knows exactly how much he will receive for his product, and he can go ahead confidently with his plans. The farmer and manufacturer uses the futures contract as a type of insurance policy to hedge against unforeseen price fluctuations of their end products. These people are termed hedgers. The hedger is the person who wants to be sure of getting today’s contract price for his product. He is prepared to forego making extra money if the price should be higher at the end of the contract.
The speculator is the person who trades futures strictly for the money, and can either make, or lose, a fortune on a contract. The hedger would go short on the commodity, knowing that if the commodity prices move below the contract price, his losses on the spot market will be offset by his profit on the futures contract. However, the speculator who would hold a long position is not covered in this way. If the price drops below that in the contract, he will have to bear the loss himself.
Speculators fulfill the extremely important function of providing liquidity in the futures market, without which the entire system would be in jeopardy.
Trading Futures Contracts
When you enter the market by going long, you take a position as a buyer. That is, you undertake to buy a certain amount of the commodity at a fixed price on a fixed date. To leave the market, you therefore have to go short, that is, you undertake to sell the same amount of the commodity on the date concerned. The offsetting contracts cancel each other, meaning you have no further obligations, and are out of the market.
Marking-to-Market
When a transaction is initiated on the futures market, SAFEX requires your broker to collect from you a ‘good faith deposit’, usually called the initial margin. If the market moves against you, you may be required to ‘top up’ the margin. Conversely, if the market moves favourably, money may be added to your margin account. This daily crediting or debiting of your account is called marking-to-market, and is based on prices prevailing in the particular contract at the close of trading.
Leverage
In financial terms, leverage implies using a relatively small sum of money to control something of far greater value. For example, by putting down, say, R35 000 it is possible to control futures contracts worth about ten times as much. If you have thus gone long of ten contracts in the JSE gold index, each up-tick of one point represents a gain of R100, and each down-tick a loss of a similar amount. (The term ‘up-tick’ and ‘down-tick’ refer to small movements up or down respectively.) The potential for making or losing great fortunes is inherent in speculation on the futures market.
Financial Futures
As with commodities, financial futures were primarily created for hedgers. For example, a pension fund manager may control a very large portfolio of stocks. He anticipates an imminent decline of say 200% in the market. Instead of large-scale selling, which probably would initiate or aggravate the declines, he can sell the share indices short on the futures market. If his judgement proves correct, his profit on the futures will offset the decline in value of his share portfolio.
Similarly, an investor who is planning to buy shares at some future date can ‘lock himself in’ at today’s prices if he foresees that the market will rise before he is ready to make his purchase. Again, liquidity in the market is provided by the speculators, without whom the whole system would become inoperable.
Trading Financial Futures
The main financial futures contracts traded in South Africa are: The All Share Index, the All Gold Index, the Industrial Index, the 3-month Bankers’ Acceptances (BA), the Eskom 168 loan stock (E168), and the Gold Price.
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| Warrants |
A Warrant gives the owner the right to buy or sell a share in a listed company at a set price on or before a set date. Thus there exists two warrants for every underlying share, one giving the owner the right to buy at a price, the other warrant giving the owner the right to sell at a given price (not necessarily the same price).
With warrants, you do not have to exercise your right. You may have paid 100 cents for the right to buy De-Beers at 3500 on the 28 February. However if De-Beers are trading at 3000 cents on the 28 February you most certainly would not want to exercise your right to pay 3500!
Warrants are bought at a substantially lower cost than the actual share as when you purchase a warrant, you own nothing other than the right to buy/sell. If you decide to exercise that right, you then have to pay the agreed upon price to obtain the shares. A Warrant can depreciate down to zero (How much would you pay for the right to buy De-Beers at 3500 in a week time if they are currently trading at 1000 - probably nothing!), however it has unlimited upside growth (limited to about the difference between what they are trading at and the price you can buy/sell them at)!
When purchasing a warrant, make sure you know the basics:
What is the underlying share - If you buy a De-Beers warrant, the underlying share is De-Beers.
What is the strike price ? - This will be the price at which you will be entitled to buy or sell the underlying share if you decide to exercise your option to do so.
What is the Cover Rate ? - This is the number of warrants you must own for every share you are entitled to purchase.
If a stock has a cover rate of 5, then you must own 5 warrants for every one share you need to purchase.
Bottom line multiply the warrant price by the cover rate to get a proper perspective!
What is the Expiry Date ? - This is the last date on which you can exercise your right. You can exercise it on any day prior to this date if you so desire.
What is the warrant type ? - Basically you get two types of warrants, one entitling you to buy at a price and one to sell at a price. Warrants will be either Call warrants (usually having a C suffix eg. For De-Beers, SB-DBR-C4) which entitles you to Buy at a given price. Or you will get a Put warrant (usually having a P suffix eg. For De-Beers, SB-DBR-P4) which entitles you to Sell at a given price.
Finally, who is the issuer ? - This is the institution that issues the right to buy/sell the given shares and is usually a bank. In the example above, if you bought a SB-DBR-P4 warrant, the Standard Bank (SB) promises to let you buy De-Beers shares from them at the given price. If the wheels fall off, you cannot moan at De-Beers, Standard Bank holds or drops the can.
The benefits of a warrant is that you retain the same exposure to the company, but only require part of the capital to do so.
As an example, consider two warrants for Old Mutual shares.
The cover is 10:1 and hence you require 10 warrants to buy/sell a single share.
The Call warrant entitles you to Buy at 2000 and the Put warrant entitles you to sell at 1700.
Old Mutual was trading at about 1500.
The warrants are issued with about a year to expiry and traded as follows over the first few weeks:
| Share Price | Call (i.e. Buy @ 2000) | Put (i.e. Sell @ 1700) |
| 1490 | 32 | 45 |
| 1500 | 32 | 50 |
| 1450 | 30 | 49 |
| 1540 | 31 | 52 |
| 1750 | 42 | 41 |
| 1440 | 22 | 43 |
Since the cover rate is 10:1, on the first day it costs you 320 for the right to buy a share at 2000.
It also costs you 450 for the right to sell a share at 1700.
Neither option will make you any profit at this point,
but the intention is that those who obtain a Call warrant expect the price to be far higher than 2000 in a year’s time
and those that obtain Put warrants expect the price to be far lower than 1700 in a year’s time.
If you had bought 10 Puts (cost 450) and 10 Calls (cost 320) on the first day shown above, then if the price of Old Mutual falls below 1250 (1700-450), you could exercise your right to sell and make a profit.
Should the price at any stage go above 2320 (2000+320), you could exercise your right to buy at a profit.
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| Commodities |
Commodities are not shares, but actual items such as precious metals (Gold, Silver, Platinum), normal metals (Tin, Zinc, Lead, etc.), bulk food items (Maize, Wheat, Frozen Orange Juice, Beef, Mutton, etc.) and so forth.
Each of these items will be sold in a certain amount called the contract size (1 ounce of Gold, 1 tonn of Wheat, etc.). Contracts may be traded in lots of 10, 100 etc.
In the commodity market, you undertake to take delivery of what you have bought at a given price on a certain day. You have no option but to take delivery and pay the agreed upon price unless you have sold the contract to someone else.
Both Options and Futures can be taken out on commodities as discussed in the relevant section. In South Africa there is not much trade in the commodity market. At best there is small trade in the Maize and Wheat futures.
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| Options |
An option is a financial instrument giving its holder the right, but not the obligation, to buy or sell a security at a specified price (know as the strike or exercise price), on a specified date (known as the expiry date). The underlying security may be a share, an index of share prices, a commodity, or a gilt.
A Call Option
This option gives its holder the right to buy the underlying security at a fixed price on a fixed date. A call option would be bought if a rise in price of the underlying security was expected.
A Put Option
This option confers on its holder the right to sell the underlying security at a fixed price on a fixed date. You would normally buy a put option if you expected a decline in price of the underlying security. Incidentally, this ability to benefit from price declines is extremely important in primary bear markets.
Gearing (also known as leverage)
When dealing with options, the term gearing or leverage refers to the phenomenon by which a small percentage movement in the price of the underlying security produces a disproportionately large movement in the price of the option.
In the Money Options
This term denotes an option which has intrinsic value. In the case of a call, the option would be ‘in the money’ if its strike price was less than the current price of the underlying security.
Out of the Money Option
This term refers to an option which has no intrinsic value. With a call, this occurs when the strike price is greater than the current price of the underlying security.
At the Money Option
This is the term used when the strike price is equal to the underlying security price.
Option holders and option writers
When you buy a share, someone else is selling it. Similarly, when you buy an option, someone else is selling it. The person who buys the option is called the option holder; the person who sells (or creates) the option is referred to as the option writer.
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| Derivatives |
The items that we have been discussing are sometimes lumped together and called “Derivatives”. This is because all of these markets, the Futures, Warrants, Options etc. have their price determined (derived) from their underlying securities, which may be shares, a share index, commodities, precious metals, currencies, bonds, gilts, etc.
Derivatives date back to as far as the 16th Century when Japanese rice cartels were seeking some kind of protection for the forward sales of their products. In other markets derivatives provided both suppliers and users of commodities with a means of protecting themselves against fluctuating prices. It is theoretically possible to create derivatives for virtually anything traded in reasonably high volume in an open market, and where prices depend on the interaction of supply and demand.
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| Forex and Crypto-Currencies |
The rate at which one country’s currency can be exchanged for another country’s is known as the exchange rate.
Thus the term for the rate of exchange of a foreign currency is often just called Forex (FX).
Foreign Exchange can be bought and sold and thus traded directly or through Futures, options and so forth.
Forex is always referenced as a pair (i.e. EUR/USD or USD/GBP, etc.) and represents the rate of exchange of the one currency to the other.
There is no central market place for the buying and selling of foreign exchange.
It is usually done through large banks and institutions.
As such there is not universal official price as with Stock Exchanges where for instance the LSE will give a single definitive price for the stock Barclays on a given day.
Rather each bank or institution will state their own rates for a given currency pair and depending on who their customers are,
may provide more or less favourable rates for certain pairs as they trade then more/less often.
Usually the rates published on the Internet/TV are an average compiled from a number of key players and you will note slight differences in
values provided by key data providers such as Reuters, Bloomberg’s, CNN, EasySoft and so forth.
Crypto currency is a digital or virtual currency that has been specially created so that it is impossible to counterfeit.
They are not issued by any central authority or government and thus are not regulated.
They also are not backed by any physical asset (In theory a country backs the value of its currency).
Crypto currencies are, like all exchange rates, referenced relative to another currency.
Thus you will hear of Bitcoin being quoted in USD or GBP or other Crypto-Currencies such as Ethereum.
There will usually be a specific Crypto-Exchange that will facilitate the buying and selling of a number of different Cryto
currencies and you will have a virtual ‘wallet’ in which your crypto coins are kept.
You should now understand what Forex, Crypto-Currencies, Gilts, Options and Futures are all about.
Most investors will not venture into these markets.
If you think you may need to, then you are advised to find out more as these volatile,
highly geared markets can quickly reduce even an experts capital to even less than zero!
As mentioned at the end of Lesson 5, there is more to technical analysis than what has been presented so far and the
area of Point & Figure charting and Wave analysis will be discussed next in the final Lesson - Lesson 7.
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(You can also obtain this Lesson as a PDF document from our Services Menu, or click here)
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