Derivatives - Futures and Options
Derivatives are exciting stuff — you have probably heard something about them in the news, normally concerning the banks losing lots and lots of money. Barrowloads of cash. Hundreds of millions. Billions. Tales of greed, fear, intrigue, treachery. The jargon is heavy and rich, the talk of high finance and rocket science...
So why on Earth would anyone want to go near derivatives? Aren't they the Wild West of investing? I am scared.
Like many things, the reality is less dramatic than the stories in the press, but the reader must do some work here; there are many new technical terms, and it all may seem overwhelming. Be patient.
Basic Definitions
Derivatives are a class of financial 'instruments' — a set of things, of financial objects, having a monetary value, and which can be bought and sold, just the same as company stock, or a ton of coffee beans — but are different because they derive their value from some underlying financial entity, i.e., their worth depends on the worth of something else, so there is a degree of abstraction involved. This can make the consequences of holding a derivative hard to fathom, e.g., a derivative can increase in value when the value of the underlying entity decreases — but it is precisely this flexibility which makes derivatives really useful.
The origin of derivatives trading goes back to commodity traders who used futures to hedge themselves against disadvantageous price fluctuations when bringing goods to market, i.e., they basically pre-arranged the buying or selling prices of what they were producing. Doing this allows one to lock-in a level of profit, thus making cash flow more predictable and so can help a great deal in financial planning. Companies do this kind of thing a lot, e.g., to protect themselves against currency movements, or oil price surges, or whatever — even the weather.
This practice of reducing risk — hedging — is the good side of derivatives. Of course, there is always the converse — if you are laying off risk to someone else, why should they want to take it on? Simple really, they believe that by assuming your risk, they can make money — they are speculating on the market. Speculating often gets a bad press but is essential to the working of the markets; these only function properly if they are liquid, i.e., it is possible to both buy and sell an entity; speculators provide this liquidity.
Futures
A futures contract is a strong agreement to buy or sell something at a fixed price on a fixed date.
Futures are almost always settled by opening a position and then closing it, i.e., you buy a future and then you sell it back later on, hopefully making a profit. Actually taking delivery of a ton of coffee beans would be unusual, unless of course, you run a Starbucks franchise. A futures contract is defined by the amount, strike price and expiry date (delivery date, in theory).
Futures began with commodities as the underlying entity, the object being the reduction of risk to the producers of these commodities, and the chance to make money for speculators wishing to take on the risk, but naturally are available in a large number of varieties these days, e.g., individual equity futures are available on LIFFE, and have recently become available in the US.
Options
An options trade is a contract — there are two parties. The buyer of an option has the right, but NOT the obligation to buy or sell an agreed amount of the underlying entity at an agreed price on or before a specified future date. Note the difference from a future — you may have the right to buy at a set price, but if when the time comes, you can buy cheaper on the open market, then you can simply leave the option unexercised. This makes options less risky than futures.
There are a number of parameters which define an option -
- The underlying entity — is usually a market index or an individual share price, although this can be anything at all.
- The style can be US or European. US options can be exercised at any time up to the expiration date, while European options can only be exercised at the expiration date. US options are thus seen as slightly more valuable, and a bit more dangerous; however US-style options are rarely exercised any significant time before their expiry.
- The type of the option. This can be either a call or put. A call is the right (but not the obligation) to buy the underlying at the strike price; a put is the right to sell at the strike price. A call holder can make a profit if the underlying increases in price; his maximum loss is the amount he paid for the option. A put holder profits on a declining underlying.
- Expiry date. Options can only be exercised up to, or on a certain date, depending on the style. Expiration dates are the third Friday of every month for index options and the third Wednesday of the month for equity options. Most of the time an option is not exercised; usually a trader will 'close his position' by buying back the option, i.e., making the inverse trade — so if you bought 10 calls, then you have to sell them back to the (secondary) market, hopefully having made a profit.
- Strike price is the agreed price at which the contract can be exercised.
- Bid price is the price you will get for selling your option.
- Offer price is the price you pay to buy an option.
You have to pay an amount of money to buy an option; this is usually called the premium.
The value of an option varies over time and is characterized as having two components; an intrinsic value — the amount by which the current price is above (below) the strike price for a call (put), plus the time value which relates to the amount of time the option has left to move itself into a profitable range. In-the-money means having an intrinsic value greater than zero; otherwise an option is out-the-money.
Options can be used to limit risk, or to increase the profits — leverage — from any market movements. Options can also be used in a bewildering variety of combinations to take advantage of any anticipated market situation; here the terminology becomes very confusing as many of the more common strategies have specific names. Strategies can be broadly categorized as being bullish (market expected to go up), bearish (expected to go down) or neutral (market to stay almost constant), and with options, profits can be made in any of these situations. Of course, one should remember that to execute any trading strategy at all one must begin with a plausible notion of likely market direction, which is where the importance of good data analysis comes in.
The 'correct' price to be paid for an option is a notion of great academic interest; the most famous landmark in this area is the Black and Scholes model.
In summary, a (buying a) call is betting the market will go up; a put is betting the market will go down. Buying options is safer than selling ('writing') them since the maximum you can lose is the price you paid to buy it — the premium. Selling options is riskier since while you have a limited maximum profit — the price of the premium you received — your maximum loss is, potentially, unlimited. The main use of selling options is to generate income from fairly static stocks. In practice, most options expire worthless, and will not be exercised.
The difference between options and futures is that you are not compelled to exercise an option — with a future you have a firm contract to buy or sell, although there is no premium to pay.
The Possibilities
Once you have been exposed to the concept of a derivative, it can then be applied ad infinitum; you can have options on futures, options on baskets of indices, anything you want really. The beauty of this is that it allows a person or a company to be creative — you can tailor your trading to precisely your own needs. One simple corollary here is that — as opposed to the simple buying of stock — you can effectively be betting on the market moving down as well as up, or not moving at all. You, at least theoretically, have the potential to profit from any kind of market behaviour.
This is such an important point to grasp, especially in these times of bear markets and increased volatility, that I will repeat myself...
- Derivatives give you the potential to make money on falling markets.
What is more you can use them to increase your profit levels, or reduce your risk.
By freeing yourself from the straitjacket of 'buying stock' and losing the burden of stamp duty, general market conditions become irrelevant to you. 'All' you then have to be able to do, is to anticipate the direction of the markets movement, more often than not — and this anticipation should be left to the domain of scientific analysis, which is supplied in StockWave™.