Lesson 6 - Other Markets

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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.

Futures and Warrants Markets

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.

Gilts or Bond Market

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.

Commodity Market

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 distributor its fresh fruit, and so forth.

Options Market

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”.

Understanding Gilts and 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.

Purpose of Gilts

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 riskier than the general stock or equities market.

Bond Market Dynamics

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 amortize 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.

Investment in Bonds

Normally, these loans are made in units of 1 Million Rand (known as the contract 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 investors, 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 broker's long-term existence/integrity.

Interest on Gilts is paid quarterly.

The Bond Market

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 mean falling capital values.

Understanding Bond Values and Interest Rates

For example, when the general level of interest rates is 10%, a fixed interest security acquired for R10,000 would pay a return of R1,000, yielding 10%. During the investment period, you can sell this certificate to someone else, transferring ownership and the interest benefits.

If interest rates increase, fewer buyers are willing to purchase a bond paying 10% when they can get higher returns elsewhere, reducing the bond's capital value. Conversely, if interest rates drop, the bond's capital value increases.

Interest Rate Impact on Bond Capital Values

If the general level of interest rates rises to 15%, a fixed interest security paying R1,000 annually would have a capital value of R6,667, providing a 15% return. Calculations follow:

R10,000 × 10% ÷ 15% × 100% = R6,667

If interest rates fall to 8%, the capital value increases to R12,500 for a bond paying R1,000 annually.

Yield and Term Concepts

The concept of ‘yield to maturity’ includes fixed interest security returns, interest compounding, premiums or discounts, and overall percentage yield. Similarly, the ‘term’ affects returns, with longer terms usually offering higher yields.

Participation in the Bond Market

Standard transaction units in the Bond Market are nominal values of R1 million, catering primarily to institutional investors. Smaller investors can participate via gilt options, futures markets, or unit trust gilt funds.

Market Competition and Investment Purpose

The Bond Market competes with the money and equity markets, with rates tied to long-term interest trends. Investors primarily seek fixed income and capital growth, given interest rate predictions.

Buying Bonds on Margin

Speculators can enter the Bond Market by buying on margin, requiring a deposit against the purchase. With high risks, changes in interest rates can significantly impact margin gains or losses.

Understanding 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 a commodity (e.g., maize), a financial asset (e.g., the E168 long bond), or a notional asset (e.g., 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

Commodities are raw materials in everyday use, such as oil for petrol, wheat for bread, rubber for tyres, gold for jewellery, etc. Businesses dealing in commodities on the cash market must scrutinize current events carefully to identify future price trends, as commodity prices are determined by supply and demand.

The origin of the futures market was to help businesses reduce risks. A futures contract allows farmers, manufacturers, and others to hedge against unforeseen price fluctuations.

Futures Contract

A futures contract is:

• An agreement to buy or sell
• A standard quantity and type
• Of a commodity, financial asset, or notional asset
• On a specified future date (delivery date)
• At a price determined at the time of entering the contract

Buyer and seller are required to put down a good-faith deposit (margin) to ensure neither party reneges on the deal.

Hedgers and Speculators

Hedgers use futures contracts to secure current prices and reduce risks, while speculators trade futures strictly for profit, bearing significant risks. Speculators provide liquidity in the futures market, which is essential for its functionality.

Trading Futures Contracts

Entering the market by going long involves taking a position as a buyer. Exiting the market involves going short, selling the same amount of the commodity on the specified date. The offsetting contracts cancel each other out, leaving no further obligations.

Marking-to-Market

When a transaction is initiated, SAFEX requires brokers to collect an initial margin. Daily crediting or debiting of the margin account, called marking-to-market, reflects price changes in the contract.

Leverage

Leverage uses a small sum of money to control a much greater value. For instance, a deposit of R35,000 could control futures contracts worth about ten times as much, enabling significant potential gains or losses.

Financial Futures

Financial futures were created primarily for hedgers. For example, a pension fund manager expecting a market decline can sell share indices short on the futures market, offsetting portfolio losses.

Similarly, an investor planning to buy shares in the future can lock in current prices if a market rise is anticipated. Speculators again provide liquidity, ensuring market operability.

Main Financial Futures Contracts in South Africa

The primary financial futures contracts traded in South Africa include:

• The All Share Index
• The All Gold Index
• The Industrial Index
• 3-month Bankers’ Acceptances (BA)
• The Eskom 168 loan stock (E168)
• The Gold Price

Understanding 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. There exist two warrants for every underlying share, one giving the owner the right to buy at a price, and the other giving the owner the right to sell at a price (not necessarily the same price).

With warrants, you do not have to exercise your right. For example, you may have paid 100 cents for the right to buy De-Beers at 3500 on 28 February. However, if De-Beers are trading at 3000 cents on that day, you would not exercise your right to pay 3500!

Warrants are bought at a substantially lower cost than the actual share. If you decide to exercise the warrant, you must pay the agreed price to obtain the shares. A Warrant can depreciate to zero but has unlimited upside growth (limited by the difference between trading and buying/selling prices).

Basics of Warrants

• Underlying Share: This is the share the warrant is based on. For instance, a De-Beers warrant's underlying share is De-Beers.
• Strike Price: The price at which you can buy or sell the underlying share if you exercise the warrant.
• Cover Rate: The number of warrants required to purchase one share. Multiply the warrant price by the cover rate for proper cost estimation.
• Expiry Date: The final date to exercise your warrant rights. You may exercise it earlier if you wish.
• Warrant Type: Includes Call warrants (entitling you to buy) and Put warrants (entitling you to sell).
• Issuer: The institution issuing the warrants, often a bank. For instance, Standard Bank might issue a SB-DBR-P4 warrant.

Benefits of Warrants

Warrants offer exposure to a company with a smaller capital investment. For example, consider two Old Mutual warrants with a 10:1 cover rate:

• Call Warrant: Buy at 2000
• Put Warrant: Sell at 1700

Old Mutual was trading at about 1500. Warrants issued with a year to expiry were traded as follows:

Share Price	Call (Buy @ 2000)	Put (Sell @ 1700)
1490	32	45
1500	32	50
1450	30	49
1540	31	52
1750	42	41
1440	22	43

Profit Scenarios

If you had bought 10 Puts (cost 450) and 10 Calls (cost 320) on the first day, the following applies:

• If the price of Old Mutual falls below 1250 (1700-450), you can exercise your right to sell and make a profit.
• If the price rises above 2320 (2000+320), you can exercise your right to buy and profit.

Understanding 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.)

Each of these items is sold in a certain amount called the contract size (e.g., 1 ounce of Gold, 1 tonne of Wheat). 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 price unless you sell the contract to someone else.

Both Options and Futures can be taken out on commodities as discussed in relevant sections. In South Africa, there is limited trade in the commodity market, with small trade in Maize and Wheat futures.

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 (known 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 the price of the underlying security is 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. A put option is usually bought if a decline in the price of the underlying security is anticipated. This ability to benefit from price declines is particularly important in primary bear markets.

Gearing (Leverage)

Gearing or leverage in options 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 with intrinsic value. For a call option, it is "in the money" if its strike price is less than the current price of the underlying security.

Out of the Money Options

This term refers to an option without intrinsic value. For a call option, it is "out of the money" when the strike price is greater than the current price of the underlying security.

At the Money Options

This term describes an option where the strike price equals 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, and the person who sells (or creates) the option is referred to as the option writer.

Understanding Derivatives

The items discussed, such as Futures, Warrants, and Options, are collectively referred to as “Derivatives.” This is because their prices are derived from underlying securities, which may include shares, a share index, commodities, precious metals, currencies, bonds, gilts, etc.

Derivatives date back to the 16th century when Japanese rice cartels sought protection for forward sales of their products. In other markets, derivatives provided suppliers and users of commodities with a way to guard against fluctuating prices. Theoretically, derivatives can be created for virtually anything traded in reasonably high volume in an open market where prices depend on supply and demand.

Understanding Forex and Crypto-Currencies

Forex (Foreign Exchange)

The rate at which one country’s currency is exchanged for another is known as the exchange rate, often called Forex (FX). Foreign Exchange can be bought and sold directly or through Futures, Options, and other instruments. Forex is always referenced as a pair (e.g., EUR/USD, USD/GBP) and represents the exchange rate of one currency to another.

There is no central marketplace for Foreign Exchange trading; it is usually conducted through large banks and institutions. Each bank or institution states its own rates for currency pairs based on its customer base and trading frequency. Rates published on the Internet or TV are typically averages from key players like Reuters, Bloomberg, CNN, EasySoft, etc.

Crypto-Currencies

Cryptocurrency is a digital or virtual currency designed to be counterfeit-proof. It is not issued by any central authority or government, thus remaining unregulated. Cryptocurrencies are not backed by physical assets, unlike fiat currencies, which are theoretically backed by a country’s value.

Cryptocurrencies, like other exchange rates, are referenced relative to another currency. For instance, Bitcoin is often quoted in USD or GBP, alongside other cryptocurrencies such as Ethereum. Specific crypto exchanges facilitate the buying and selling of cryptocurrencies, and virtual “wallets” store these crypto coins.

The Risk

Forex, Crypto-Currencies, Gilts, Options, and Futures are volatile and highly geared markets that can quickly deplete even an expert's capital. Most investors avoid these markets, but those who venture into them should seek thorough knowledge beforehand.

As mentioned in Lesson 5, technical analysis extends beyond the concepts discussed. The next lesson delves into Point & Figure charting and Wave analysis. You can explore this further in Lesson 7.