Tuesday, August 05, 2008

The Invisible Derivative's Market Reprinted

This is a reprint from June 25, 2006 that may be of interest to some of you. The market went up 331 today instead of down and Google is trading higher than $375.

Call it gamblers insurance. The most common derivatives are Puts and Calls. If you think that Google is going to go down and you want to still hold it because of its upside potential you would buy a Put at say $375. So if Google was to drop to $200, you could "put it" to the option seller at $375. The cost of this insurance option varies, depending on the volatility of the stock. Now, if you thought Google was going to go to $1,000 you could purchase a Call at $400 strike price. If the stock rose to $600 you could exercise the Call and get the stock at the $400 dollar price or the difference between the Call price and the current value.

The figures vary somewhat, but about 90% of all options expire worthless in the U.S. Stock Market.

Enter the Gunslinger (slang term for wet behind the ears Mutual Fund trader) (never seen a real bear market in his life---there hasn't been one). This guy gets the bright idea to sell both Puts and Calls. As long as the market lumbers along the guy is raking in the coin.

Say the Dow has a bad day and drops 300 points. It seems like a big move, but since it is a measure of 30 stocks bought way back in 1910, multiply the 300 point drop in value by the Dow divisor (0.123) and you get a real dollar loss of $36.90 on the Dow. Divide that by the 30 Dow stocks and you get $1.23 per stock. If that were to happen, no big deal pay out to the Puts exercised. Notice, you only get burned on the Puts OR the Calls NOT BOTH in any one point in time. I stress the words "Point In Time."

The Derivatives Market is bigger than our stock market. One analogy used the comparison of an elephant to a mouse; here is a graph from one source that puts it at 35 trillion dollars.

Graph courtesy www.gold-eagle.com. [postnote:The graph is somewhat dated, present figures suggest around 55 trillion.]

Now suppose the Dow Jones drops 1000 points. Then by some miracle the market comes back to even at lunch time. Then, it soars up 1,000 points by the close. The gunslinger gets hit going down and nailed again when it goes up (the double whammy). He would be selling Calls like crazy while the market is going down trying to recoup losses from his naked Puts, then as the market heads north he gets eaten alive by the Calls he wrote earlier.

We only picked one market; there is the bond market, the commodities market, and foreign exchange markets, to name a few. At this point, the gunslinger is in a situation that looks like the kiddy game, where you have a hammer and hit the head that pops out of one of many different holes. The model turns into a real mess, when you realize that there are thousands of Mutual Fund Managers that will all be playing this game in real time. Naturally these different markets will be doing different things. The word "panic" comes to mind.

My suspicion with Mutual Funds and IRA's, is that when you specify how you want your portfolio invested, they are not moving your money from one investment to another, they are purchasing a derivative to satisfy your demands of asset allocation. This leaves them free to pursue the line of investment they feel most confident with.

So much for "what ifs," the Derivatives Market is a Fantasy Land; the playground of hedge funds and mutual funds. Where will it end? My best guess, somewhere between Ab Surdum and Ad Nausea (no, they are not towns in Iraq).


Paco Bell said...

Jim sayeth:
"The Derivatives Market is bigger than our stock market."

And to think that up until a few years ago, I hadn't a clue that such things as CDO's, MBS', Option puts and calls, and CDS even existed, if so, only vaguely, and as to how these functioned, fuggetaboudit.

My suspicion is, very few people do, either. Which is the danger, of course.

And CDS apparently dwarfs them all. Staggering. CDS apparently are the new futures too, due to their being patronized by those with not only the means to do so but who have also made their bets a more accurate indicator of a specific entity's financial health.

Jim in San Marcos said...

Hi Paco

I don't really see any way to track the Credit Default Swaps (CDS). They are kind of like a side bet with your neighbor on the Super bowl. I could be wrong, but how do you add up side bets on a horse race? The size of the CDS mess is just a guessing game. I tend to discount CDS claims because there isn't much data to go on.

I notice that San Diego didn't bother to buy insurance for its last bond offering. The reasoning was that the bond insurers were more suspect than the bonds. Insurance in any form is beginning to have a bad smell to it.

The one thing we can glean from this mess, is that things are not going quite as planned. And they are getting predictably worse.

Jim in San Marcos said...


Paco could be right about the size of the CDS. More people are becoming concerned about their status of late.

Just how big it is, is still kind of an unknown. Its a little like a sea monster that keeps a low profile. You want to see it at the movies, not while fishing off your boat.