Posts Tagged ‘options’

Introducing options as insurance

Friday, January 12th, 2007

In our previous article (How not to use options), we mentioned about options. Today, for those of you who are uninitiated to the world of options, we will give you a quick introduction. For more in-depth information about options, we recommend the books in the ?Derivatives? section in Recommended Books.

First, let us have a brief introduction on options. When you buy a call option of a stock, you are purchasing the right (but not the obligation) to buy the stock at a specific price (the exercise price in the option?s contract) on and before the option?s expiry date. Correspondingly, when you buy a put option, you are purchasing the right to sell the stock at the exercise price. Technically, when you buy a call (put) option, you are said to be entering a long call (put) option position, or simply ?long? a call (put) option.

The interesting thing about options is that you can also ?create? them for sale. When you sell a call option of a stock, you may be obliged to sell the stock at a specific price if the buyer of the option chooses to exercise his/her right to buy from you. Correspondingly, when you sell a put option, you may be obliged to purchase the stock from the buyer of the option. Technically, when you sell a call (put) option, you are said to be entering a short call (put) option position, or simply ?short? a call (put) option.

When you initiate an option purchase or sale, you are said to ?open? an option position. To ?close? an option position, you enter an opposite option transaction?sell back the purchased option or purchase back the sold option.

A good way to understand options is to see them as akin to insurance. When you enter a long call (put) option position, you are in effect purchasing ?insurance? against the rise (fall) of the underlying stock price. When you enter a short call (put) option position, you are in effect underwriting ?insurance? for the rise (fall) of the underlying stock price. So, option trading is a game of probability?the same way insurance companies are in the business of pricing probability of events for profit. Therefore, as in the insurance business, the option trader has to accurately ascertain the price of probabilities accurately in order to profit.

How not to use options

Friday, January 5th, 2007

Many people have the impression that options are ?risky? because they expire after a cut-off date. Though this impression is understandable, it indicates a misunderstanding on the use of options. As a result, options are often misused, resulting in losses?that is where its bad reputation comes from.

To elaborate on how options are misused, we first look at how people trade stocks. It is easy to understand how to profit from stock trading?buy low and sell high if you believe that the stock price will rise. If you believe that the stock price will fall, you can short-sell?borrow stocks at high price, sell and then buy back the stocks at lower price later to return the loaned stocks. In other words, to profit from stock trading, you only have to get the direction of the stock movement right (though not exactly so for short-selling, but the idea is there).

Now, when you extend this idea to options trading, it becomes a recipe for losing money. Since options have expiry dates after which it becomes worthless, getting the direction right is not enough?you have to get the speed of the stock movement right as well. Since it is hard enough to get the stock?s direction right, let alone its speed, using options as if it is a proxy for stocks will result in increase likelihood of suffering losses. Also, options prices also depend on other variables in addition to the direction of its underlying stocks (the stock that the options derive from). In real life trading , it means that in some cases, it is possible for an option?s price to fall even though the underlying stock price remained unchanged.

Thus, if you are intending to trade options the way you trade stocks, we urge you to think twice. To trade in options, you need a paradigm shift from your understanding of conventional stock trading. We will touch more on that later. For more information on how to trade options safely, we recommend the books in the Derivatives section of Recommend Books.

The ABCs of hedging

Wednesday, December 6th, 2006

One of the claptraps that we get to see nowadays is ?Hedge Funds.? According to the Encarta dictionary, the word ?hedge? is defined as: ?a means of protection against something, especially a means of guarding against financial loss.? A ?hedge fund? was originally meant for managed funds that employ hedging to protect against any market downturn and perhaps even profiting from it. Today, there are many funds that call themselves ?hedge funds? even though in reality, they do not hedge at all. Those fund managers are more akin to gamblers betting on anything that they can get their hands on, often using huge amount of borrowed money and derivatives to magnify their punts. In addition, unlike the conventional gamblers in the casino, those gamblers are usually absolved from personal losses if they lose their bets. Instead, it is often those poor investors who entrusted their money to those scoundrels who have to pay the price. Worse still, if those gamblers won their bet, they will often be the first to carve out a slice of their winnings. Thus, if you should decide to entrust your wealth to a hedge fund, please make sure the fund manager is not a gambler in disguise and that the fund does indeed hedge. There are too many quacks, swindlers and cheats in the financial industry waiting to devour your money.

Now, as a private investor, how do you hedge your portfolio? In other words, how do you reduce the risk of potentially significant losses in your portfolio?

The most well-known and basic technique is diversification, which is spreading out your investments across different stocks, industry, asset classes and so on. Unfortunately, this technique has major limitations. Firstly, though diversification reduces your risk, it also reduces your chances of making big gains. It is possible to over-diversify, which will result in mediocre returns over the long term. Secondly, diversification will not protect you against major economic catastrophe when deflationary forces wipe out the value of almost every class of investment. Thus, for investors after atypical excellence, diversification is not the most favoured method of hedging because they would rather reduce risks by increasing and improving their skills, knowledge and understanding then by scattering their eggs over many baskets. The best investors would rather concentrate their investments on the ones that they understand intimately than to spread out their investments to make up for lack of understanding. In other words, diversification is a very blunt tool for hedging.

What is the more precise strategy for hedging? For long-term value investors, there is this ?war-gaming? approach. Military planners often go through war games where they work out the outcome of all the possible scenarios and develop strategies to specifically counter each of the unfavourable outcomes. The same can be applied to investing. This risk management approach will determine how you structure your portfolio. Given each of the economic what-if scenarios, what are your plans to ensure that your portfolio will survive and perhaps even thrive? For example, what are your plans for your investments if oil prices sky rocket? What happens if the US dollar collapses? What if the global economic imbalances unwind disorderly? For you to be able to evaluate the ?war-gaming? scenarios, you would need to understand both global and local economic conditions. That is why in this publication, we often delve into economics, which some novice investors mistakenly believe is irrelevant and is the ?job? of the government.

Then there are the more tactical approaches for hedging, which is more relevant for short-term traders but nonetheless can be adapted for long-term investors as well. The most basic of these is the stop-loss. It is a tool mainly used by trader to pre-define the price which they will exit their position regardless of what their emotions tell them in the heat of the battle. Stop-loss does not prevent you from making a loss?they let you pre-define your potential loss before you enter the trade. For those more advanced traders, there are more powerful tools for hedging using derivatives. For example, delta-neutral option strategies allow you to potentially profit from all kinds of short-term market situations and limit your losses to pre-defined levels should you turn out to be wrong.

There are a lot more to hedging and risk management than we can say in this article. We hope this will be a good starting point for you.