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Financial Derivatives

 

Financial derivatives seem to have an image problem. The mere mention of the words: “forwards”, “calls” or “puts”, and many market participants will simply choose to pass. That’s because things are truly complex when it comes to financial instruments, whose value depends on another underlying asset and there is leverage involved. Better not to take the risk hence, but by that same thinking, none of us should really be driving cars. A combustion engine on wheels, being steered around busy traffic by (other) irrational humans all vying for the right of way? That seems very risky, but it does get us from point A to B, and so too financial derivatives are merely tools that allow us to express our investment views. Clearly, we need to use these instruments wisely and as instructed. We don’t light a fire and throw it into our petrol tank to get more power, so surely, we would also not buy Calls and sell Puts at the same time, because that would be insane.

 

It’s all about risk in the end and nothing lets you control risk better than financial derivatives can. Want to take risk off, just buy some puts or sell some futures. It’s one price, one instrument and the investment exposure can be as small or as large as one needs it to be. And if you want to hedge your corn production for next year, you can even sell some forwards and take all the risk of a bad harvest off the table. There really is no limit to what one can do, using options, forwards and futures to hedge existing positions or speculate on certain prices and it is no wonder the market for these wonderful instruments has now grown to more than $550 trillion in size.

 

Which brings us to the three horsemen of the apocalypse: “Vega”, “Gamma” and “Theta” or Greeks, as they are generally referred to and they are what separates the boys from the men (and the girls from the women, and the mini-transgenders from the fully grown transgenders). Thanks to the genius of Black and Scholes, who invented the option pricing model back in the eighties, we know that volatility is most important when valuing an option. Say, you like a stock at 50 and you think it is going to go to 60, then you could buy a 60-strike call option. What would be the price? That depends on how much the stock moves up or down per day (volatility). If the stock moves by 1% on average per day, it could take as many as 20 days for the stock to hit that level. Hence the probability is low that the option comes good, e.g. the stock moves from 50 to 60. However, if the stock is very volatile and moves more than 10% per day, the chances are much higher that it could hit that level. Hence the latter option is worth much more.

 

The rest is up to you and always remember if you want to keep things simple, just be a buyer of options rather than a seller. In other words, the reason that financial derivatives have a bad name is because they can expose you to unlimited losses. Back to our example and the stock we like at 60, if we buy the option and the stock goes higher, we are happy. And the most we could lose if the stock doesn’t get there is the premium we spent to buy the option. If on the other hand, we had sold said option (because we didn’t think the stock would get there and collected the premium instead) and the stock goes much higher to say 250, then we could sit on huge losses. Always remember, guns don’t kill people, people do and you still have to get your views right to make money, even with these mesmerising tools as your new best friends.

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