Saturday, June 28, 2014

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 [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).


Brian said...

I trade a lot of options for a couple of reasons.

It is a helluva lot cheaper than owning the stock. It allows traders to control a huge chunk of stock with a very small investment. It also has homerun potential as it did when the market collapsed in '08.

Truth is- my trading style is such that very often I don't hold equity positions longer than 6 months anyway. Plus once you buy a contract that's it. You know exactly how much you are in for and when that expires.

Most of my options positions expire worthless as well- however when I score it tends to be huge and more than make up for my losses.

Obviously, I am an option fan.

Jim in San Marcos said...

Hi Brian

I do the same thing. On your taxes, the government offers a 3,000 deduction on financial losses, so they subsidize my option speculation. I've seen $100 worth of options go to 87K but it won't stay at that price for long.

Its the people selling these way out of the money options that are looking for increased returns for little or no risk. Its the black swan event that kills them with unimaginable losses. This is probably what a lot of fund managers are doing to increase their yields.

dearieme said...

Not for me; I don't now have the appetite to follow markets closely, and could presumably suffer great loss if, for example, ill-health distracted me from paying attention. (Heavens, in early Spring 2003 my FIL's ill-health was enough to distract me - pity, equities were particularly cheap then.)

I did look into this area once: it was thinking about counterpart risk that was the clincher - it was Credit Lyonnaise I was worried about, though it was Lehmann's that eventually sank.

dearieme said...

Jim, I wondered whether this might interest you.