Things to Know about Flow Derivatives in Financial Markets

Summary:

Flow derivatives are known to maximise leverage. They are synthetic directional bets and might come with built-in features like stop loss. They are based on the value of indices, currencies, etc. In this article, we will talk about the world of synthetics, how flow derivatives work, and provide you with a classic example of the same.

A flow derivative is a kind of securitised derivative that utilises the process of optimum leveraging to make large financial gains with little movement in a market’s value. The flow derivative is dependent on the movement of value in the trade of currencies, indices, stocks, or commodities that are related to a set of assets. Flow derivatives are typically traded on exchanges.

Flow derivative: The concept

Investors can make directional bets on the price of currencies, commodities, or an index through flow derivatives. They can copy the payouts of over-the-counter (OTC) products, thereby providing the feasibility of being exchange traded. Traders get access to real-time pricing since flow derivatives are traded on electronic platforms, which makes trading easier for them.

Flow derivatives, which are a part of synthetics, are created to streamline trading and make directional or trend-driven trading better. This is typically done by flow derivatives where they combine the functions of two or more trades into one product.

While the aim of synthetics is to make directional bets smoother, it doesn’t necessarily mean ease returns. They can be very complicated, especially in uncertain markets. The real-time nature can be challenging when a trader is wrong on the directional trade, or they are on the right path but start trading at the wrong time. Cash or futures positions in flow derivatives tend to lose money in real time when compared to a future settlement date.

Types of flow derivative financial instruments

There are various kinds of flow derivatives, such as the vanilla option, WAVE, the barrier option, etc. All flow derivative instruments are set to increasing or declining values in exchange for rate fluctuations for currencies. Since the derivatives are traded in real time, the currency trading platform moves fast. Typically, an investor investing in stock has to wait before the order is filled based on volume and other factors. However, an order is placed automatically in the case of flow derivative, and speculators take positions on increasing or decreasing values with the financial instrument.

A contract between a buyer and seller where a particular currency is matched against another, and a specific date is fixed is known as a spot position with a flow derivative. Spot positions as of 2010 accounted for over one-third of all trading that took place on FOREX. Spot positions come into play a couple of days after the agreement is reached apart from a few currencies like the US dollar and Russian ruble. 

Forwards are another kind of flow derivative position. The financial instruments have open-ended dates which the trading parties fix in the beginning. The transaction is closed on the predetermined date irrespective of how the currency value has changed in the intervening time.

Option trading positions, on the other hand, are another kind of speculation on the currency exchange. The options owners do not have the obligation to trade the same on the prefixed data. Options are more feasible when compared to other kinds of flow derivatives and thus, they happen to account for the bulk of trading on the FOREX exchange.

Components of flow derivatives

The components of flow derivatives drive their tie-up with underlying assets. WAVE XXL, for instance, typically known as a leveraged synthetic spot position, is also called perpetual future at times because of the lack of a set maturity and built-in stop-loss feature. Investors, in this case, are safeguarded from suffering a loss of the invested capital and cannot lose more money than their initial investment.

WAVE XXL calls allow bullish traders to make a leveraged bet on the rise in the underlying with a built-in stop-loss. And there is a product for bearish traders, a WAVE XXL put, which positions the trader to generate profit from a decline in the underlying with a built-in stop-loss.

Due to this, even small increases in the underlying can be multiplied by several times to maximize gains or losses significantly. The reason is that derivatives use leveraged products like options or futures, where the investor does not need to purchase the underlying asset. The investor pays a small premium or put up margin for the accessibility to the full price movement of the underlying.

A classic example of real flow derivative

The structure of the product can make flow derivatives a bit challenging. WAVE XXL, offered by Deutsche Bank, can be a classic example. 

If a trader thinks that S&P 500, currently trading at 3,000 points, will show growth over time they would purchase a WAVE XXL call. While an index certificate is priced at $3,000, a WAVE XXL call can be bought at only $4.

This scenario is achievable because the product uses an S&P 500 funding level of 2,600, resulting in a 400-point difference. A cover ratio of 0.01 incurs a $4 cost (400 * 0.01). A 6% stop loss is set at 2,756, and the product's price tracks the S&P 500 point-for-point, subject to specific conditions.

Interest, at a 5% rate, accrues daily but is added to the funding level. After one day, the funding level increases to 2,600.36, and the call is priced at $3.9964 ((3,000 - 2,600.36) * 0.01). The stop loss also rises by 6% alongside the funding level due to interest.

The position will be stopped out if the S&P remains stagnant, while a decline in the S&P 500 triggers the stop loss. A profit is made if the S&P rises. For example, if the S&P 500 increases to 3,300 within two months, interest costs total 21.6 points (0.36 * 60 days), elevating the funding level to 2,621.6 (2,600 + 21.6). The call's value becomes $6.784 ((3,300 - 2,621.6) * 0.01), resulting in a 69.6% increase despite the index's 10% rise.

Flow derivatives are known to maximise leverage. It is advisable to partner with a leading broker to know about the same. Research well before you take any decision.