By Christopher M. Barra, MS
Does anyone really understand “Derivatives”? The past scandals regarding this investment animal had many people wondering: “What the heck are these things I never heard of doing in my conservative mutual fund”? Derivatives have been around for a long while, but we normally refer to them as something else using different more common descriptions.
The word “derivative” literally means “derived from”. Those who studied calculus know that F (x) = . . . ./? never mind, now I remember. I studied calculus and couldn’t possibly explain it that way. In more simple terms an investment that is derived from another investment is called a “derivative”.
A stock certificate may seem as though it is intangible, just a fancy piece of paper, but it represents ownership of a company which has a real value. The most common derivative is not tangible thing like a stock or a bond. It is a piece of paper representing what we think that stock or bond might be worth at some point in the near future - very esoteric. A derivative can not survive by itself. Its worth is based on the underlying security from which its value is derived. Don’t give up on this yet - it gets easier.
An option is a common derivative. Lets start with the simplest of option transactions, the purchase of a call option. A call option is an agreement that gives the holder the right to buy a certain amount of stock (usually 100 shares) at a specific (strike) price. This option usually costs about 10% of the value of the stock it is based upon. An option lasts for about three to nine months during which time the buyer may cash in (exercise) the option and make a profit, or limit his loss. If no action is taken during the option period, it expires worthlessly.
Let’s try to bring this discussion to a more familiar level. Start by thinking of an option to buy as the same idea as a purchase on a lay-away plan. There is a beautifully designed, teal colored completely outfitted bungee jumping harness and gear set beckoning you from the display shelf. This set even includes an instruction manual, first aid kit, and a free $19.95 do it yourself last will and testament software program. It costs $1,000, the original sales lay-away price. You give the store $100 to hold the bungee kit until you can get back to cash in your lay-away ticket with the rest ($900) of the money, or six months whichever is later. If it was a call stock option on a block (100 shares) of stock, that $100 is not refundable. A good department store may or may not refund your money if you don’t buy the bungee kit within the lay-away time period.
You did not yet buy bungee jumping equipment, only the right to purchase it. You exercise the right to buy when you bring the rest of the money.
Three things can happen to the price of the bungee jumping gear during your lay-away (option) period. It may increase, it may decrease, or it could remain the same - not all that hard. When you think of it, those are the only three scenarios possible with any investment.
If the price increases, say by 20% to $1,200, your lay-away agreement still allows you to buy the set for $1,000. You may be able to offer your lay-away slip to someone else who intends to start jumping. The option shows that another $900 more is needed to buy since the agreed upon price was $1,000 and $100 has already been paid. How much do you ask for your lay-away slip? Maybe you can get $250. Someone is sure to buy it in order to get for themselves a $50 discount off of the asking price. After all, they will be paying $1,150 total (the $250 for the lay-away slip plus the $900 needed additionally) for something fairly valued at $1,200 and going up. Maybe they would even pay more for the option, given the direction of the price.
Regardless of whether you get more or less than $250 for your $100 option, you can easily see that the return from the option in terms of percentage yield (150%) far exceeds the increase in price of the rigging (20%). This amplifying of returns is one of the reasons people get such a thrill out of investing in options. For some it gets the adrenaline pumping just like a Las Vegas casino, and it is legal in every state.
A decrease in price can occur. Assume now that for some reason from the time the money was put down and before it was bought, bungee jumping becomes unpopular. Documented brain damage reports hit the tabloids, faulty straps are discovered, cordless jumps become trendy, health insurance premiums increase and who knows what else. Now stores are trying to clear them off of the shelves to bring in the new, more popular shark wrestling equipment. The gear has fallen from $1,000 to $750 in price and has made its way to the discount rack. Will you now go to the store present your lay-away slip and pay $900 to complete the buy? Of course not, if you still want the rigging you will forget the option and pay $750, losing the $100. Here again, the percentage decline in the option value (all of it or 100%) far exceeds the percentage decline in the value of the asset (25%). The percentage return, both, positive and negative is magnified with options.
PRICE REMAINS THE SAME
If the price of the bungee gear remains the same, you may decide to buy the gear or not, probably you will because you would not have bothered to put the equipment on lay-away if you didn’t want it. The lay-away slip is not worth anything to anyone else because any stranger can buy for $1,000. No one would bother to buy it from you at anywhere the $100 premium paid because they would not save any money off the price of the gear. If the price stays at $1,000, you normally either buy it or lose the deposit.
If you decide that you really don't want to bungee jump after all, that you would prefer square dancing, you could sell your lay-away slip at a loss. Maybe here someone will pay $50 for it in order to get the gear for a total price of $950. In this case you received $50 for something which had become worthless because you had decided not to buy the gear, yet it had certain value to someone else.
If you substitute the words “corporate stock” for “complete bungee jumping kit”, “call option” for “lay-away “, “strike price” for “original sales price” and “exercise” for “cash in” you may get the idea of how the derivative “call option” works.
The buyer of a call option hopes that the stock will increase in value beyond the strike price so that he can capitalize on the enhanced return by either “calling it in” to himself and buying the asset at a now bargain price, or selling the call at a premium to someone who may want the underlying stock. If the price doesn’t increase it clearly will not be wise to buy at what becomes a higher price than is readily available on the free market.
The seller of a call hopes that the price remains the same, or fall. If it remains the same, the seller may keep the option income. If it falls, the option will not be exercised and he again keeps the income. If it increases in price, he must deliver the bungee kit... er the stock he agreed to provide. This will cost him more than the option income provided, especially if he does not currently own it.
The seller of a call does not have to own the stock to offer a call for sale. He can sell a call on a stock he does not own and hope he doesn’t have to buy the stock for delivery to the buyer. This is dangerous because if he is wrong, and the buyer exercises (cashes in) the call for profit, he now must buy the stock at the higher price to deliver to the call holder at the agreed upon lower price. The seller of an “uncovered” or “naked” call is at very high risk. The reward is the possible receipt of option income without having to provide any asset as collateral.
A “Covered Call” seller is one who actually owns the stock on which the call is written. If he is wrong and the stock increases, he still loses, but he has the stock already and probably bought it at a lower price than the current market asking price. He also has the call option premium income to offset the loss. This derivative strategy is used by investors who believe their stock is good, but going nowhere soon. They are trying to increase current income. Option income funds employ this strategy because the downside risk is much lower than by writing uncovered or naked calls, and they can increase income for the fund without much risk.
A put option works in reverse. Instead of the buyer being able to “call in” in property at the stated price (strike price), the buyer of a “Put” option is able to put the price of the item to the seller at any time during the option period. The seller of the put must deliver the stock on demand.
In the example above, if you buy a put option on the gear rather than a call, you would be counting on a decline in price. If the price declined to $750, as the owner of the put you could force the buyer to buy at $1,000, the original strike price.
If you sell the put option, you are obligated to buy at some specific price during the option period. You are counting on the price to rise. The premium paid to you for the option obviously increases your income. If you are right, the income may be kept without having to fork over the stock. The seller of the put hopes that the price stays the same or increases so that the put income stays just that and he doesn’t have to deliver the stock to the buyer, or make up the difference between the put price and its increased value.
Derivatives are usually employed by mutual funds to reduce risk, not to increase it. The fund normally takes the opposite position with the option (hedge) than they take with their more tangible securities (stocks & bonds). When a mutual fund manager is concerned that one or more of the holdings of the fund may soon become volatile, he may buy a put. When there is uncertainty as to whether the stock will go up or down, he will buy a put option. Remember the put gives the right to “put the investment to” someone at a stated price. So if the stock does indeed fall, the manager “puts” it to the buyer at the higher agreed upon stated price, thereby maintaining most of the value of the security in question, protecting against loss.
If the stock does not lose value as expected, the put option expires, the cost of the option is not wasted. It is looked upon as an insurance policy. The manager had already determined that this minor risk was worth it to avoid a more serious loss which may have occurred had the underlying stock lost a significant portion of its value.
A manager might buy a put if he is concerned about volatility in either direction, up or down. Should it go down, he can exercise the put, putting the stock to the buyer. If the stock goes up, he will participate in and be pleased by the gain, but lose the put option premium paid. This is a reasonable cost for what amounts to very logical and conservative insurance protection for the underlying stock value.
Investors who write (sell) puts are obligated to buy a stock if the price reaches that specified during the time period. The premium received increases current income to the seller at a time when the stock price of the shares is expected to rise. If the price never reaches the strike price, usually within nine months, the put premium becomes income to the seller and a short term capital loss to the buyer.
WRITING (SELLING) CALLS
Assume the same scenario as above, the ownership of a stock expected to decline. The seller (writer) of a call option would be trying to increase the return from the stock by the amount of the call premium received. This option also provides protection against a decline in price of the shares. If the stock increases in price, the potential capital gain will be lost because the buyer of the call will exercise the option, (buy the stock). This strategy will limit the upside potential of the stock.
A manager would not write a call if he expected that there was a good chance that the underlying stock price might increase substantially. The call premium would not be worth the sacrifice of large capital gains.
Ever hear of Pork Bellies? Ever buy them? No one really wants cargo train loads of pork bellies or for that matter “February Coffee” heaped on their front porch. What is February Coffee? Simply the price of coffee that is expected to be paid for coffee in February. These are examples of “Futures”. Common futures trades are for harvestable grains, coffees, food, and natural resources (metals). Speculators try to guess what the price may be months in advance, and go long or short on their guess. Since they don’t really want to buy the actual item, they unload the future sometime before delivery by paying the difference to the broker, or collecting the difference from another willing buyer.
We have stock market futures. What do you suppose the S & P 500 stock index will be six months from now? Will it go up or down? You can buy an option to make a guess on this. This is an interesting animal. If a derivative is derived from another investment, what is a market future? The S & P 500 is not an investment, but an index (indicator) of the market. Market futures are kind of like the cousins of derivatives once removed.
Market futures are sometimes used by mutual fund managers to try to hedge against poorly timed investments. For example, if a fund happens to have a large exposure in aggressive growth stocks they believe may be in jeopardy, they may buy an index future betting on a decline in the market. If the decline actually comes, the premium for the market future (option) will be magnified in terms of gain, offsetting at least part of the loss attributable to the loss in value of the stocks. If the decline never comes, the future premium is lost and as in an earlier example considered a worthwhile portfolio insurance policy premium.
Options are bought and sold every day. Huge sums of money are made and lost without the underlying security on which the options are based ever changing hands.
Derivatives are somewhat complicated, but more often than not the reason we can’t understand them is because they are not explained very well. We have taken a little different approach her in the explanation and hope that the subject is a little more clear.