Derivatives - Hedging or Gambling

[chinaco]

I have noticed a few people employing derivatives. Most notably some form of options.

It seems to me that there are a number of reasons to employ options. The sober reason is to hedge. Some use them to try to juice up gains.

Short of having superior knowledge to the rest of the market, It would appear to me that using them to juice the numbers up... is a little more like gambling. [ Especially since the market is fairly efficient in pricing. ] It is kinda like an all or nothing bet. No doubt, some investment houses seem to have the quants and savants that can divine a security's future direction better than most... but it take alot of analysis, access to information, a team of smart people with a little luck!

So... assuming that one (an individual person saving for retirement) does not need the money in a certain period of time... Why would they employ an option? It seems to me that if an asset dips (and it is otherwise healthy) it will eventually come back... therefore going long and rebalancing would seem to be the most cost effective approach.

The only common reason I can see for using options is if I had an asset that (if it dropped in value) in the period of time before I could sell it, I would experience problem (i.e., use like insurance).

Thoughts?

 

[saluki9]

A common reason people employ options is if they don't have the free cash sitting around to buy enough of a certain security to have an impact on their situation. Options allow you easy leverage.

 

[2B]

All derivatives I have seen are some form of options. For a period of time you can buy, sell, be forced to buy or forced to sell. For this you pay or receive a fee. In time the derivative will expire unless exercised. Some of them can be very complicated.

With a derivative you take on a risk. It's just a different kind of risk than you take with just owning the basic financial instrument (stock, bond, etc.).

It's speculation any way you try to explain it. I see the best use as "portfolio insurance."

 

[dmpi]

The only option I might try, is to buy a put to hedge the stock I can't (or won't) sell because of tax reasons. And I'd only do this if I think the market is going to crash.

 

[ambition187]

options can give a high-risk/high-reward profile.

for example, Amazon went up like 40% a couple weeks back after earnings. Suppose someone took an aggressive position that the earnings would be great and the stock would shoot up, by buying highly out of the money call options (say $55 strike when the stock is at $40 ish). Out of the money calls went up x30 (meaning a $1000 investment would be $30000 after the jump!)

so with small money (relative to your portfolio) and some confidence, you can get some nice returns. of course anything can happen so only do that with $$ you can lose (it is basically gambling)

 

[Gone4Good]

Not all uses of options are "high risk gambles" . . . selling covered calls is a good example.

Also many firms / sophisticated investors use derivatives to hedge away very specific risks they don't want to take. An example is a corporate bond fund manager who hedges his portfolio against treasury moves using interest rate forwards. This allows the manager to focus on selecting the right corporate credits for the portfolio rather than having the portfolio dictated by interest rate expectations.

Lots of very good reasons for firms and sophisticated investors to use derivatives. Although much ink is spilled about the "riskiness" of derivatives, these products allow the dissemination of risk from those who don't want it, to those who do. In aggregate, they make for a more stable system.

 

[Olav23]

You could also use it to hedge away market risk from a . For instance, you pick a stock that you think is going to do well, but at the same time, you have a sense that you are fighting the overall trend of the market. So you can hedge away the market (by using options on the SP500 or whatever) and go long the stock. This way you are neutral to the market and positive towards a stock. Speculation, certainly, but yet another "tool in the toolchest".

Also, I brought up an ETF that is supposed to be coming out any day now based on the S&P 500 Buy-Write index (BXM). They use a mechanical passive system of selling a near-the-money call option on the S&P500 index every month. Some months the s&p goes down and it gets "called away" and the investor collects the premium. Other months, the index goes up and the option expires worthless. You are basically giving some of the upside potential to the downside protection, but it has shown to work well in studies, dampening volatility. I think it is pretty innovative.

 

[FinallyRetired]

It's been said that options is the crack cocaine of stock trading addiction. I traded options for a couple of years and tend to agree. I made large returns early on, which sucked me in, then lost all my gains very quickly when I was on the wrong side of the trade. Learned valuable lessons and have not traded options since. If you do options, there are two safe ways to do it, covered calls and married puts. But remember, it's like a "safe" amount of crack.

 

[brewer12345]

I've used derivatives to both hedge and gamble. Derivatives are tools, and all tools are only as good as the use their a put to. But while a currency ETF is akin to a hammer, options are probably closer to a nail gun.

 

[chinaco]

Not all uses of options are "high risk gambles" . . . selling covered calls is a good example.

Good point. Covered call limits the potential call loss if it sky rockets in price. But you give up the upside of just owning the asset. Where as a naked call has potential unlimited loss. If the asset goes up 1,000,000% you have to cough up the asset.

Interestingly enough, writing a naked put has a similar premium gain, but the writer expects the asset to go in the opposite direction... still, the loss is limited to the current asset value.

Options introduce an expiration time which changes the risk profile (as opposed to going long)... Plus there are ways to limit the amount lost if the writer loses (but they pay for it).

On the buyer side... it seems to me that the goal is to maximize leverage or hedge.

It is interesting.

If I buy a call to get the upside if the asset increases, I am trying to gain... it is a bit like taking a gamble. That investment might be based on information or knowledge (but so is gambling on the outcome of a football game).

On the other hand, if I buy a put to ensure that I do not lose my shirt on an asset because I need to hold on to it... it is considered a bit more like insurance. It seems a bit more prudent!

 

[Olav23]

I've heard some people employ a strategy to create a "structured product" of basically buying bonds/tips with most of your portfolio and then a ladder of index call options for the upside potential of the equity market. At the worst case, you make the interest from the bonds and lose what you paid for the options. At the best case, the options become in the money and you collect this on top of the interest.

Has anyone looked into a strategy like this?

 

[chinaco]

Someone mentioned them on the board. This seems to be a growing area of securities. They look a bit complicated in the sense that they have many provisions and some restrictions.


I think one would really need to study them closely to understand exactly how it may benefit or scr3w you.

 

[clifp]

I use covered calls to diversify out of a concentrated position, provide income, and hedge. On occassions I write a naked put in order purchase a stock I want to own but who's current price is more than I want to me. For me options acts as stop loss or limit order, but since I am almost always writing options I am getting paid a pretty good premium for them.

In general I am willing to give up some of the upside benefits of owning stocks in return for lower volitality and income. For me I used them more like insurance than gambling.

 

[brewer12345]

I've heard some people employ a strategy to create a "structured product" of basically buying bonds/tips with most of your portfolio and then a ladder of index call options for the upside potential of the equity market. At the worst case, you make the interest from the bonds and lose what you paid for the options. At the best case, the options become in the money and you collect this on top of the interest.

Has anyone looked into a strategy like this?

This is a replication of what equity-indexed annuities do, but a lot cheaper and more flexible. I'm not wildly thrilled with the strategy, but it is a lot better than EIAs. Not tough to do, either.

 

[Olav23]

Thanks Brewer. I did a bit of research on the EIA that you mention. If anyone else is interested:

Principal protected ELNs (Equity-Linked Notes) give investors participation in the upside of the stock market without any risk to the downside. For instance, a note might offer 100% participation in the increase in the S&P 500 over the next five years. However, if the S&P 500 falls, you get your money back. Wow, most all of us say, that's pretty cool.

One of the keys to an ELN's attractiveness is how much participation it gives an investor in the equity market. If you can get a 100% participation rate, that is pretty good although you won't get any dividends. But if you are only getting 40% or 50% of the price appreciation, it is not a very good deal. If price appreciation averages 8% and you get 50%, that's only 4% at high end. If the market is down, you get your money back, but zero return. Why not just buy a 10-year bond and lock in 4.5%?

Participation rates fluctuate widely over time and are primarily influenced by interest rates and option prices. To illustrate how this works we need to dig a little deeper into ELNs. Most ELNs combine a zero coupon bond with a call option on an index like the S&P 500. The zero-coupon bonds provide the principal protection and the options provide the upside exposure to the market.

Zero-coupon bonds are sold at a discount to their face value and mature at their face value. Assume the face value of a bond is $100 and one-year interest rates are 11%. You could buy a one-year 11% zero-coupon bond for $90 and after one year it will mature at $100. If the stock market has declined, this $100 can be given back to the investor to make good on the principal protection.

Moving to the option side, after spending $90 on the bond, there is $10 left to buy call options. If options cost $10, the fund could buy one option for each bond and give investors 100% participation in the price appreciation of the market. However if options cost $15, the fund could only buy 2/3s of an option for each bond. This would result in a 67% participation rate (10 / 15 = 0.67).

Hopefully, you can see that an investor's participation rate is dependent on two factors. The first is interest rates which determine how much money can be spent on options. And the price of options is the other critical component. When options are cheap, investors get a higher participation level then when they are expensive. Option prices are impacted by a number of factors but generally speaking the expected volatility of the market is the most important factor.

It is easy to see why ELNs are very popular when interest rates are high and option prices low. In England in the late 1980's, these products took off, especially for investing in Japan. British interest rates were very high and Japanese options were very cheap. Investors could easily get 100% participation or more without risking any principal. They were called 90/10 funds as 90% was used for bonds and 10% for options.

Today interest rates are low and long-term options are not cheap. These two factors work against investors getting high participation rates and at this time no product comes close to offering a 100% participation rate.

http://www.farmcreeksecurities.com/Sound_Investor21_Equity-Linked_Annunities_10-26-05.html