Flow Derivative: Meaning, Components, Example

What Is a Flow Derivative?

A flow derivative is a securitized product that aims to provide maximum leverage to profit from small movements in the market value of the underlying. Flow derivatives are typically based on the value of currencies, indexes, commodities, and in some cases individual stocks. Some popular flow derivatives include vanilla options, leveraged synthetic spot positions, and synthetic structured forwards. Flow derivatives are traded on exchanges or other electronic platforms.

Understanding the Flow Derivative

Flow derivatives are designed to allow investors to make directional bets on the prices of currencies, a basket of currencies, a commodity, or an index. Flow derivatives can mimic the payouts of over-the-counter (OTC) products while offering the ease and transparency of being exchange-traded. Because flow derivatives are traded on electronic platforms, traders can access real-time prices and place trades automatically.

Flow Derivatives and the World of Synthetics

Flow derivatives are part of the world of synthetics. These are products that are designed to simplify trading and make directional or trend-driven trading easier. Flow derivatives do this by combining the functions of two or more trades into one product. For example, a synthetic structured forward can combine a long call option and a short put option into a single product with a customized time period.

While synthetics attempt to make directional bets easier to make, that doesn't mean they are easy products to understand or to make money on. These products can be extremely complex, which means issues can arise in terms of accurately pricing the product in volatile market conditions.

The real-time nature of synthetics can be problematic when a trader is wrong on the directional trade, or they are right on the direction but enter the trade at the wrong time. This is because the cash/futures positions in a flow derivative lose money in real-time rather than at a settlement date in the future. How this happens is explained in the example below.

The Components of Flow Derivatives

Flow derivatives trade in and of themselves, but their components are what drive the relationship to the underlying assets. For example, a WAVE XXL, which is a leveraged synthetic spot position, is sometimes called a perpetual future because it has no set maturity and a built-in stop-loss feature. This means that investors are typically protected from losing all the capital they invested, and can't lose more than they invested.

WAVE XXL calls are flow derivatives that allow bullish traders to make a leveraged bet on increases in the underlying with a built-in stop-loss. The opposite product for a bearish trader, a WAVE XXL put, positions the trader to profit from a drop in the underlying with a built-in stop-loss.

The leverage is built right into the product and can take a small increase in the underlying and multiply it several times for a much bigger gain or loss. This is because the derivatives are using leveraged products like futures or options, where the investor is not required to buy the underlying asset, but rather pay a small premium or put up margin to gain access to the full price movement of the underlying.

Example of a Real Flow Derivative

Flow derivatives are a directional bet but they can get a little bit complex depending on the products underlying them and how the product is structured. Take for example a WAVE XXL. These products are offered by Deutsche Bank.

If a trader believes the S&P 500, assuming it currently trades at 3,000, will move higher over time they could buy a WAVE XXL call. An index certificate would cost $3,000, but a Wave XXL call could be purchased for as little as $4.

This is possible because the product uses a "funding level" for the S&P 500 of 2,600. The difference between the funding level and the current level is 400 points. A cover ratio of 0.01 is used, which provides the $4 cost (400 * 0.01). A stop loss is set 6% above the funding level of 2,600, at 2,756. The price of the product will move point-for-point with the S&P 500, but there is a catch.

Each day the product charges interest, but the interest is tacked onto the funding level. At 5% interest, the funding level rises to 2600.36 after one day (2600 / 365 days * 5%) + 2600). The call is now worth only $3.9964 ((3000 - 2600.36) * 0.01). As the funding level price rises each day due to interest, so does the stop loss, staying about 6% above the funding level.

If the S&P 500 doesn't move, eventually the position will be stopped out because the stop loss price will eventually reach 3,000. If the S&P 500 drops, it will be stopped out by reaching the stop loss. If the S&P rises, the trader makes a potential profit.

Assume for a moment the S&P 500 rises to 3,300 over 60 days. Interest costs are 21.6 points (0.36 * 60 days). The funding level is now 2,621.6 (2,600 + 21.6). The value of the call is now $6.784 ((3300 - 2621.6) * 0.01). The call originally cost $4, and is now worth 69.6% more, even though the index only rose 10%.