Finance 101: Part 4, extension – Derivatives

Last post completed a listing of various savings vehicles.  In sum, one can purchase a variety of securities (e.g. stocks, bonds) and/or strategy funds.

Let’s complete the picture with probably the most complex, and potentially risky, component of an investment portfolio: derivatives.  These instruments can be used for a variety of purposes, as part of an overall portfolio.  Unfortunately, they require close scrutiny; their inbuilt leverage means you need to monitor your portfolio at least daily.  That probably excludes most savers.

In any case, here we go:

  1. Options (puts/calls): these are contracts between buyers and sellers, with reference to some underlying asset (usually shares of stock/indices, or futures contracts).  The option contract gives the buyer the opportunity, but not the obligation, to buy the underlying (in the case of a call) or sell the underlying (put) from the option seller.  So if I buy a call option on AAPL stock, I pay someone for the opportunity (but not the obligation) to purchase AAPL at a pre-decided price.  For the opportunity to do that, I pay the call seller a small premium.
  2. Futures: these are contracts between buyers and sellers, with reference to some underlying asset (e.g. shares of stock/indices, certain amounts of commodities, bonds).  The futures contract gives the buyer the obligation to buy the underlying at a future date, at a pre-decided price.  So if I buy a futures contract on soybeans, I have agreed to buy a set amount of physical soybeans, for a set price, at a specified date in the future.  I don’t have to pay a premium for the futures contract – I just post some surety margin with the exchange, to honour my obligation.
  • Benefits of derivatives:
    • Leverage: instead of using borrowed money to buy securities, one can use futures and options.  Both have inbuilt-leverage: after all, both are just contracts between buyers and sellers, and both parties want the leverage.
    • Flexibility: particularly in the case of options, the user can specify maximum loss vs maximum gain and/or probability of success.  Instead of basing gains/losses on underlying gaining in price, these derivatives allow shorting and neutral positions (e.g. positions which make money when the underlying doesn’t move).
  • Drawbacks of derivatives:
    • Leverage: having the ability to make levered bets is a blessing and a curse.  At its worst, poor money management can wipe out an entire portfolio – even with a relatively small move.
    • Complexity: particularly in the case of options, these are influenced by several factors other than underlying price moves.  Unless the user understands all the contributors to option value, profit/loss will come for unknown reasons!

Reasons I use derivatives in my portfolio:

  • Defining maximum loss: I like the feeling of knowing exactly how much I’m going to lose in a worst-case scenario.  For example, with the stock market vacillated around all-time highs, I’ve replaced my underlying securities with options; now my maximum loss is the premium I’ve paid for the position.
  • Inexpensive leverage: margin debt is expensive, and I don’t like the idea of needing to liquidate holdings when the market falls (see 2008).  I can achieve the same, or better, leverage with options at a lower cost and no need to worry of forced liquidation.
  • Getting paid for time: option values are partially determined by time to expiration – therefore the option seller receives payment (through the amortisation of option premium) for passing time.  Combining this point with the above 2 points, I can get paid for time passing.

In summary: derivatives give a lot more flexibility to an investment portfolio, but requires a lot more TLC.  Most savers won’t ever touch these, but for folks with an interest in derivatives I can recommend the guys over at tastytrade for information resources.

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