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Options and Futures- Worth the Trouble?

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moonbackground I had wanted to explore more what options and futures are. After reading Peter Lynch’s “One up on Wall Street” which Lynch puts a pretty persuasive argument for investors not to engage in such tools, I decided to go look around to find out more to see what it is really like.

I hope that I can add a little bit more to the knowledge pool of such investment tools or are they a sucker’s game?

In case you don’t know what are options and futures. According to Wikipedia, a Futures contract is promise to buy or sell a specified commodity or standardised quality at a certain date in future and at a market determined price (the futures price).

They are a type of derivative contract. That means that they aren’t stocks but they are derived from it and get its value from it. And they have an expiry date or delivery date.

In a futures contract, the holder is obliged to make or take delivery under the terms of the contract, whereas an option grants the buyer the right but not the obligation to establish a position previously held by the seller of the option.

Confused? In simple English, it means the owner of the options contract (to buy) can cop out, but both parties of a futures contract must fulfill their contract on delivery date.

What about an example?

Example of a futures contract (extracted from the Wikipedia article on futures contract:

Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90. This means that the "mark-to-market" calculation would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts, to the holder of the other side of the future. That is, the loss party wires cash to the other party.

In other words, it is much like a zero sum game, where one party gains at the expense of another.

But in a stock market, there can be a win-win situation, where the owner of a stock sells for a profit to another who later sells for additional profit in a rising market for example.

When I look at the futures article in Wikipedia, my thought was that it not worth the trouble to analyse. But I remember the example of Nassim Taleb who went on to reap great returns by placing bets against the markets and making a killing when there are “Black Swans” events.

Basically he bets that fat tails (statistical anomalies- at the extreme ends of statistic  curve) are more common than the financial mathematical models allow for. A reason why the collapse of the financial markets caught all of them with their pants down- they didn’t allow a higher possibility that the market will go down. Go figure.

However, I’m not him and I don’t know how to make such a killing, and it looks more complicated than what those futures workshop are advertising it as. If their system works, everyone will become a millionaire by now. And by necessity, every winner must have a loser in the derivative market. I just think I’d end up losing and the presenter wins in both the lessons fees and betting against  all the novices and me.

Also I steer clear of any margin product as I am quite risk adverse. I can’t make myself borrow money to invest. Its like borrowing on the credit card 24% per annum interest  to earn a miserly return of around 7-9% per annum. And even the 7 to 9% isn’t even a guaranteed return.

So thanks but no thanks. Sexy products like this are not for me.

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2 comments:
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financialfreedom said...
February 3, 2010 at 10:15 AM  

Hi,

Thanks for your well wishes on my job search.

I used to think that options were "risky" too. But then I realised that they are only risky if you use them wrongly.

Options are meant to protect you against certain risks. When used correctly, I think they provide you with a less risky portfolio per se. Just think of it as buying insurance for your stocks.

Do note that I have never dabbled in options before so I am just giving my 2 cents worth.

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Lemizeraq said...
February 4, 2010 at 12:12 AM  

Hi FF,

Thanks for visiting.

Yeah, I read that derivatives are weapons of mass destruction by Warren Buffett. Then Nassim Taleb piqued my interest when I read his book on Black Swans.

Then I have to read Peter Lynch book, one up on Wall Street where he gives very easy to understand reason why someone like him doesn't want to touch options.

And me being risk adverse in that sense, I agreed more with his position after finding out more about it.

:) Hope you have job offers flooding in.

Lemizeraq

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