SMSF Investing Education & Strategies

Derivatives overview

A type of investing that has become more prevalent over the last decade for SMSF trustees is trading derivatives.

Derivatives are financial contracts / instruments, whose values are derived from the value of an underlying asset (like a stock, index, or commodity etc). The main types of derivatives traded are Futures, Options, Warrants, and CFD's (contracts -for-difference).

 

Derivatives can be used to reduce the risk of economic loss arising from changes in the value of the underlying asset. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying asset moves in the direction they expect (either up or down). This activity is known as speculation. The key aspect of derivatives is that they are leveraged instruments, which means that a small move in the underlying asset can mean up to 10 to 25 times that move in the price of the derivative. Very high return potential, but also very high loss potential, so careful, prudent money management is required.

 

SMSF technical note:  derivatives are allowed in SMSF's, however you must articulate your parameters in your written SMSF Investment Strategy, and if you are trading any options or futures which have a margin requirement, then you will need a Derivatives Risk Statement (as per Reg 13.15(a) of the SIS act). In our Document Samples section we have sample templates of these documents that you can use. Also see our articles in the SMSF Technical Education & Strategies section on trading futures and options in a SMSF, and the ATO ruling on CFDs.

 

 

To trade derivatives in a SMSF you will need:

1. Education in derivatives

To understand the nature of derivatives, and the market your investing / trading in. Get educated !

It is imperative that if you are going to trade highly leveraged and volatile instruments such as derivatives, you seriously need to understand the nature of the markets your investing in, and the ways in which derivatives work (and how they can blow you up if things go even slightly askew). Get educated - education is always your best investment. See our sub-menu items underneath the Derivatives button, which have a range of educational material covering warrants / instalments, options, futures, and CFDs,

 

2. A derivatives broker

This is all about price, reliability, product range, and what features they offer that suit you and the type of investing / trading you want to do. Derivative brokers may be online or phone based (or both), and may also offer advisory trading services. See our Online broker comparison table as a starting point for DIY traders.

 

3. A sensible trading method or strategy, using research and derivative selection tools

If your going to be successful at trading derivatives, you absolutely need a logical plan or methodology for selecting your positions that is underpinned by a robust, prudent process. There are a number of research tools and services that can assist with this:

 

Investment newsletters / Trade rec services (see our Investment Newsletter comparison table)

These are services that (hopefully) are run by professionals that have a lot of experience in the derivatives markets, and essentially tell you what and when to buy and sell. They are very handy for those that are time poor, who still want to use expert guidance. Due to the highly speculative nature of derivatives, you will want one that has a track record of recs over a decent period of time so you can see how they have fared in the past. You should also fully understand what their trading strategy is.  Be careful and highly selective - don't trust "back tested" results only

 

Trading Software / Trading systems

Trading software and Trading systems can come in a number of different formats. Fundamental analysis software sits on your computer desktop (or is web based), and via a number of filters that you can overlay yourself, tells you which stocks (and hence their derivatives) have the best fundamentals or financial strength subject to your search criteria (e.g. you might only want the best in the  top 100 stocks, or only those with PE ratios less than a certain number etc). This is a very useful tool for only including top quality, financially strong companies in your portfolio. Technical analysis software looks at entry and exit points of stocks, indices, commodities etc from a technical analysis or "charting" perspective. This is generally used by trustees who are more actively trading derivatives, however some can be used by those taking longer term positions. Trading systems are those where a particular set of indicators are used (which may or may not include the use of software) to provide the you with buy and sell signals for individual stocks, or the market as a whole. All of these above may be initially delivered via an 'Education' course or DVD package so that you understand what the investment philosophy is all about and how to use the trading software or system they are selling.

 

4. Documentation

As always, you need to make sure your trust deed allows you to trade the derivatives you want, and you will need to include what your doing in your written SMSF investment strategy. For options and futures only, if there is a margin requirement you will need a derivatives risk statement. See our Document Samples for examples of these that you can use as  a template for creating your own. We have specifically included items such as derivatives in these documents to assist.