The Invisible Derivative's Market Reprinted

This is a reprint from June 25, 2006, and later Aug 5, 2008 that may be of interest to some of you.

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 Whack a Mole, 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).

Nest Egg Inflation

As I get older, retirement seems further off in the distance. Inflation is nibbling away at my savings. But there are bigger problems that lie hidden just beneath the surface.

The Robert Reich movie "Inequality for All," talks about the 1% getting richer and the middle class getting poorer. On the one side, the middle class still earns the same amount, but it doesn’t go as far anymore. This is called inflation, but a better description would be government printing of dollars. If we look at the rich getting richer, one item eludes people, the increase in wealth doesn’t mean that they now spend more, it most probably goes into a bank account. These extra dollars are not sloshing around in the economy, they have been absorbed into what could be labeled a “wealth sponge.” The excess of printed dollars is effectively removed from circulation.

On top of that, we have many people approaching retirement squirreling dollars away in their IRA’s and 401K’s. Many people believe that Congress enabled these retirement plans to help people save for retirement. That concept was a great vote getter, but the real reason for these plans was to increase the money available for Congress to borrow.

In two years’ time, my mint flavored Altoids have increased in price from one dollar to three dollars. The dollar double cheeseburger at McDucks is now $1.69. On Reich's documentary, he interviewed a guy making 12 million a year, and the gentleman pointed out that he only needs three pairs of blue jeans a year. So we can’t depend on the rich to stimulate the economy, and at the same time, I’ve cut down on double cheeseburgers and Altoids. Put it another way, the burn time on retirement funds has halved.

People today, are not saving for retirement like they used to. The silver foxes are starting to withdraw their retirement dollars, while the young question the concept of even saving money. Why put it in the bank at one percent when you can get a new car instead? Interest rates this low almost demand that you satisfy your urge for immediate gratification.

If we go back to Bernie Madoff, we stumble upon another problem not considered. All of his investors were rich up until they were advised he was broke. It's amazing how an excel spread sheet and a LaserJet printer can give an investor the appearance of a fabulous monthly statement, while in reality they're dead broke and clueless of the fact.

The real feat of accomplishment, is the 14 trillion dollars borrowed by the US government. It was sucked out of the financial system in a span of 10 years. This money was deposited in the banks when interest rates were 8% and higher. What happens now, when the baby boomers retire and start to withdraw their nest egg dollars? What happens if there are no new dollars coming into the system to replace the ones withdrawn?

It's kind of like the government selling 14 trillion dollars worth of tickets to the latest movie and the theater only seats 2,000. There is no problem until you decide to see the movie.

inflation has had 40 years to ravage your nest egg. As you run out of funds in retirement, your kids will try to help you out and will come to the conclusion that you just didn't save enough. They will grow up wiser--- When it comes time for them to retire, they can use their government Social Security checks to pay off their government student loans. ---Why do I get the feeling that I'm missing something here?

The Computer Age, The New Brick Wall

Computers have changed the way the world works beyond imagination. Just as in the early 1920, the industrial age transformed the United States from an agrarian economy to an industrial one. The 80% farming the land in 1910 didn’t give up willingly, but the number of farmers dropped drastically as the Great Depression progressed. That was the “New Age” of; incandescent lighting, the telephone, electricity, the airplane, radio and the automobile. This new technology was going to make life better, and that was 1929. And it did for some.

Our present economy is in bad shape. Raising the minimum wage is not going to make better hamburger flippers, minimum wage jobs are already filled to beyond capacity. People need to realize that the work place has change dramatically with the introduction of computers, many jobs are gone for good. Try going to the Unemployment office to file a claim; you have to get on a computer and fill out the forms, and god help you if you can’t type. Just entering your data for a claim yourself, eliminates about 4 people that use to work in the unemployment office; the receptionist, the data collector, the interviewer, and the guy to match you up with a job. Type in your claim and the computer will search the data base and print out possible job positions and at the same time, determine if you are eligible for unemployment.

People without computer skills are the new frontier of unskilled laborers. Surprisingly college grads also enter into the unemployed mix. Many field have no jobs waiting for them, this includes lawyers, dentists, and health care techs. There are jobs in those field, but not tens of thousands of them. Colleges don’t guarantee jobs, they only enable the student to pursue the career selected. It is not their fault that more people will graduate this year as lawyers as there are people already practicing law.

Then you have middle management who have lost their jobs because of the computer revolution. One worker with the right software can now replace twenty people. Many people over 45, even with retraining, can’t expect to receive half of what they were previously earning--it probably took them 10 years to get to their present pay level. So they collect two years of unemployment and retire early at age 62.

This new age of technology has caught everyone flat footed just like it did in the roaring 1920’s. You could even go back to about 1906 when the mechanical calculator went into production and discover that the hundreds of thousands of accountants employed by the banking industry disappeared overnight. One person with a calculator replaced 80 workers.

Jump forward to today. The internet supplies us with many services we used to pay for. With Google, you can fix a washing machine, replace a garbage disposal or replace the brakes on your car. You can sell odds and ends to the rest of the world from the comfort of your own home.

Computer technology has made all sorts of tasks simpler and easier to accomplish. So it’s not surprising with all of the software, around, entrepreneurs have figured out that it is more cost effective to move simple repetitive jobs overseas. So in effect, we have a double whammy, a new work paradigm that revolves around computers, and an out sourcing of jobs that can be done cheaper in the third world.

The frustrating thing about the new technology is that you can spend a whole day on the phone trying to get a live person to talk to. And when a real person answers, you'll discover that you're talking to someone in India with an extremely limited English vocabulary; -- which proves you can work in this country without even being here. Theoretically a person in Hong Kong could robotically flip hamburgers in the US at 40 cents an hour---That has to be easier than flying a drone half way around the world and launching a stinger missile into Afghanistan. Let's see, I'll have one drone-burger, hold the onions and the missile.

Computer technology is the future. The trouble is, it's has transformed the labor market without telling anyone, leaving many people ill prepared or too old for tomorrow's jobs.