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Derivatives: A Survival Guide

By: OptionsANIMAL
Posted: 9/17/2012 11:43:00 AM
Referenced Stocks:

By Martin Tillier

I would wager that before 2007 most mainstream investors had not even heard the word “derivative” other than as a dismissive description of a song or movie. During the financial crisis, however, the word was everywhere, usually with scare quotes. There were articles, seemingly every day, claiming that derivatives were the problem. They were bad things, designed to take investor's money away and further enrich the fat cats on Wall Street. They were inherently flawed and always had been doomed. They should be banned. Market insiders put on their “wry smile” face and muttered “This too shall pass…” to themselves. Overreaction usually looks ridiculous with hindsight.

Now that the hysteria has died down, it may be a good time to address a few basic questions:

In market terms, a derivative is, as its name implies, an investment vehicle whose value is derived from something else. They come in many forms and many levels of complexity. The best known and most widely used are probably futures and options. At their simplest, both give the investor the right to buy or sell an asset at some time in the future. At the other end of the spectrum are complicated, esoteric things like the VVIX. This is a measure of the volatility of the VIX. The VIX is a measure of the volatility of options. In other words the VVIX is a derivative of a derivative of derivatives! It’s no wonder people don’t trust them.

The problems of 2007-2009, however, came from a different type of derivative, the dreaded bundled mortgages. In theory, they were, and still are, a good idea. The principle of diversification to reduce risk is understood by most investors. That same idea is behind Mortgage Backed Securities (MBSs). If you own one mortgage and the borrower defaults you have nothing. If you own a piece of hundreds, or thousands, of mortgages, that risk should be diluted. The problem, though, was not in the theory but in the practice. Firstly, the assumption was made that the default rate on a large number of mortgages was predictable. We all know how that worked out. Secondly there is some evidence that Wall Street firms knowingly bundled bad risks together in order to bet against them using another derivative, a credit default swap. The relative importance of these things, along with the role of the ratings agencies and the government, have been debated at length and are not at issue here. The point is that many public investors were buying things and not understanding the risks.  They therefore felt aggrieved when they lost money.  

This does not mean that derivatives should be avoided. Rather it means that a little homework goes a long way. Options in particular are useful to many investors. Covered calls can generate income, and puts can provide protection. More advanced strategies can provide profit in flat markets, or lock in profit taking and stop losses at little or no cost. It is important that you understand what you are doing and the risks involved, however. That is why at Options Animal we focus heavily on education.

The answer to the last question “what should you know before getting involved” is fairly simple. It is the same as you should know before buying any security.

Notice that I did not say that you must understand every facet of how the instrument does what it does. The hysteria after the crash had us all believing that no derivative should be touched as we couldn’t possibly understand how they work. If we applied that principle to everyday life we wouldn’t buy anything. I mean, who really knows how their phone works? What we really need to know is; if A happens how much will I lose, and if B happens how much will I make.

Don’t be afraid of derivatives as some wooly concept. Use them to your advantage. They are not risky by definition. It depends how we use them. In the case of options, even if trading them on a daily basis is not for you they may well have a purpose as part of an overall investment strategy. Certainly don’t dismiss any investment just because it is a “derivative”.