Before diving into the subject, and considering that investment is a sensitive topic, I have to provide the following disclaimers:
The term derivative includes multiple products that have been created artificially from a stock. That means that they do not represent a part of a company nor a business. They are agreements, usually carried out by a third party, that can be exchanged in official exchanges.
In general, they are considered more risky than stocks. Some people even qualify them as pure evil. However, they have a reason to be, and “handled with care” are not worse than stocks. However, something to have clear is that they are mostly speculative products, not so much as investment, as you do not “own” any business.
The most common derivatives are:
Each derivative has a particular goal, there are some of them which are more of gambling items, like the ‘binary options’, that you either win or lose to a given item. Others imply that you are “playing” against a market maker, whose interest is that you lose money. And so on…
Then, why do I bring these items here??? Because among all the “madness” you can use them to “hedge” (cover your positions) and do asymmetrical bets. Keep on reading to see how to use options to cover your positions and do asymmetrical bets.
BEWARE: Leveraging is dangerous. Make sure you understand the implications
First some disclaimers about leverage. Read this section of you are not familiar with it!!!! One of the key aspects of the derivatives is the leverage. Leverage means that your real exposition is bigger than your actual position. How? Easy: you are used borrowed money. Either the broker or the “creator” of the derivative is charging you some interest on that position, and it is often priced in the product. The key thing to remember is that you are playing with money that you do not own. If things go south and you don’t have extra money to cover the leverage the broker can close your position triggering a margin call (like the movie!).
Directionality means that you can bet for movements in positive or negative direction. That is possible because the derivative is synthetic and created by a third party, so you can actually go long or short. This is what makes them powerful as hedging strategies.
When working with leverage all the movements get amplified, which is very nice when they match your expectations, but can be dreadful when they don’t. To understand it better, let’s see an example.
For instance, there is stock valued at 10€, and you can get a derivative that it is equivalent to 100 stocks, with a leverage of 10x, therefore a unit product of 100€ (10€ * 100stock /10 leverage).
Therefore, make sure that you have a proper margin (create a comfortable leverage). By “blocking” extra money, you can lower the effective leverage:
Watch out with “daily leveraged” products. That is a very obnoxious thing that happens in products like some leveraged ‘daily’ ETFs. Their leverage/price is calculated on the
%, when the index moves 2%, the ETF moves 4%, when the index moves -2% the index moves -4%. Watch out however, that
% is not symmetrical, to recover a -50% you need a +100%. Below 10% that asymmetry is low, but it gets composed day after day… and can get pretty ugly (see the Oil ETFs during the oil futures crash of 2020)
Watch Out! Each broker and product has a different margin requirement. Some futures have as much as 20x leverage. Be careful, and make sure you understand them and their implications. If you don’t, just avoid them altogether.
When you buy an option you are purchasing the right to buy (or sell) something at a given date at a given price. For that you pay a premium. The premium basically prices how likely that is to happen.
Pay attention! There is also the option of selling options. In this case you are obliged to your part of the contract, either buying or selling something. In exchange you receive a premium. Selling options limits your gain to the premium received, but it can lead to unlimited losses. See the subsection of selling PUTs for details.
When you buy an option, its value at the strike date is (not considering the premium):
|Option||Right to||strike < stock||strike > stock|
|CALL||Buy||0||Stock - Strike|
|PUT||Sell||Strike - Stock||0|
Due to those characteristics, Options give you some interesting capabilities. Typically, they are considered as “plain” speculative positions, for either the stock goes up (CALL) or it goes down (PUT), but the actual interesting part of the options are the advanced cases:
In the video below, Patrick Boyle onFinance explains the payoff diagrams for Put and Call options. If a picture is worth a thousand words, a video should be worth a million.
If you are interested in finance, I totally recommend you to subscribe to Patrick Boyle YouTube channel . He has a lot of content and even courses that will allow you to understand how options are priced and why.
Remember! Selling options can bring unlimited losses, even higher than your initial investment!!!!
Once clarified that, there is a particular case of interest which is selling PUTs. By selling a PUT you commit to buy a something at the strike price on the strike date. In some cases, if the options can be executed in advance, you may be forced to buy sooner!
Why would you do that? Basically to collect the premium. You can see it in different ways:
It is important to note that, as an insurance, the more risky the item is the more it will pay. A good quality stock with good trajectory will pay little. At the same time, as an insurer, you don’t want to be taking stupid risks randomly. A good concept here is to either settle for very low premiums or do this operation with stocks that you would like to have at a given strike price.
Also, thinking as an insurance company, you do not want to have a bunch of correlated risky items, because if there is a black-swan (like the Covid19 crash in 2020) where all stocks go down, all your sold puts could be executed, leading you with a complex situation.
Unlike stocks, options strategies can be extremely complex, remember that you have 4 quadrants (BUY/SELL + CALL/PUT) plus time dimension. That opens the door to gazillion options with options… hahah, poor joke, I know.
The most basic strategy is a spread. A spread is to have a long and short position simultaneously, which reduces your overall exposition. With options you can use either a different strike price, strike time or both.
I am going to put here some examples with ASML. You can see ASML’s option chain in IEX website At the time of writing this and taking the screenshot (9-March-2021), ASML was trading at 442€.
Below you can see a traditional table with the option prices, in this case with strike date of 17 December 2021. In the center you have the strike price, in the left the CALLs (with decreasing price as strike price goes up) and in the right the PUTs (with decreasing price as strike price goes down). The four quadrants operation is achieved by having the option of Buy/Sell each option (represented by the green/red buttons respectively).
Note that previous picture is just a subset of the options that are close to spot price. On 15 February the stock was at 500€, and 400€ in January. So if we want to go to more out of the money options we have to expand that list to get the following ones:
We can play with these values creating some strategies
Considering that this last event has been just a hiccup, you can buy CALLs. The more out of the money they are, the cheaper they get, but also the faster they lose value as time goes by or movements in the opposite direction occur.
Note that CALLs at 450€ are 46€ each, CALLs at 540€ are 20€ each and CALLs at 600€ are 13€. We can buy 3 times the calls at 600€ strike price than at 450€!!! But of course, 600€ is +33% above 450€… which looks far if we ignore that ASML pretty much doubled in last year.
The advantage of this approach compared with buying the stock is that we know our maximum loss is limited to the premium payed (4600€ on the 450€ CALL and 1300€ on the 600€ CALL). Let’s see a table for some cases:
|CALL strike||Total Cost||ASML = 400€||ASML = 500€||ASML - 700€|
Note that even with the stock at 500€ with the CALLs at 450€ we get little benefit. That is because we paid a hefty premium. The real benefit point is 450€+46€, or an equivalent price of 496€. With the 600€ calls, the benefit point is at 613€.
Note also that when the stock goes up a lot we can get many times the premium paid, that is the asymmetry of it.
If we don’t want to tap into the unlimited benefits, we can cap them by selling a CALL, which helps to decrease the premium.
For instance, in the case above, by buying (K) the 450€ CALL and selling (V) the 600€ call, we would be paying 4600€ for the first and receiving 1300€ for the second, which results on 3300€ premium.
If instead of selling 600€ CALL we sell the 540€ CALL, we limit the benefit to 9000€ and decrease the premium to 2500€ / benefit point to 475€
In the same table as above
|CALL strike||Total Cost||ASML = 400€||ASML = 500€||ASML - 700€|
|450€ K - 600€ V||3300€||-3300€||1700€||11700€|
|450€ K - 540€ V||2500€||-2500€||2500€||6500€|
This kind of approach is often used to create structured products.
This approach is one of the nicest ones of the options. But first of all, you should like the company. If you would not have a bond of that company nor stocks… you should not do this!. Having said that…
Let’s say that you are interested in ASML, you think that in the long term it is a good business, but you don’t want to pay more than 400€ for its stock. At the same time, you have a fair amount of cash that you would like to get some interest, but the bank gives you 0.01%. You really like ASML, you thought of buying their bonds, but then you found out that they are 10 years with a 0.25% interest (!) and you think it is completely absurd.
In this particular case, you can do a “cash secured sold PUT”, which means you sell a PUT for which you have enough cash to cover that whole position (100x strike price). Remember! Selling a PUT can lead to the loss the full strike price position (100x strike price). Your broker will always require you a proper margin! Only do this if you understand this!
To make it round, let’s say you sell a PUT with a strike price of 400€. That requires you to have 40.000€ cash to secure that PUT. You could get away with half, but you have no issues. For selling that PUT you get a premium of 3150€ (31.50x100).
Now the following scenarios can occur
The fact that the losses can amount to 100x strike price does not let you sleep at nights. To prevent that, you do a spread coverage by buying a PUT at a lower value. You are positive about ASML and set a loss limit of 10.000€. For that you have to buy PUTs with a strike of 300€ (400-100). Their premium is 8€, so your neto premium is 2300€.
Now let’s revisit…
This approach is so interesting that you can even bring it to the limit:
|PUT strike||Premium||Equiv. Price||Max loss||interest||interest over max loss (*)|
|300€ V - 280€ K||135€||298€||2000€||0.45%||6.75%|
|420€ V - 400€ K||800€||412€||2000€||1.96%||40%|
|400€ K - 380€ K||600€||394€||2000€||1.5%||30%|
Note two particular cases:
(*) If your broker does not force you to buy the stock but liquidates the difference with the stock price, you can calculate the interest over the cash required to cover the maximum loss. Needless to say, that 40% is because it is very likely to get triggered.
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