Hey there, time traveller!
This article was published 14/5/2010 (3381 days ago), so information in it may no longer be current.
IN the wild kingdom of investment, it seems derivatives are among the most fearsome of beasts. This species of finance, which includes credit default swaps and synthetic collateralized debt obligations (CDOs), is largely blamed for our Great Recession.
But not all derivatives are necessarily risky and complex investments.
In fact, derivatives are often used to manage risk rather than add risk to a portfolio. For the investor who trades stocks, bonds and exchange-traded funds (ETFs) through an online brokerage like iTrade, the only derivative they'll likely ever use is an option.
An option comes in two forms: a put and a call, and an investor can either buy or sell an option.
But what can options do for the average investor? Think of them as investment insurance, says David Derwin, an investment adviser with Union Securities in Winnipeg.
"What you're insuring is a stock, bond, currency or commodity because you can protect against prices going up or prices going down," Derwin says. "You buy a call if you think the market is going up, and you buy a put if you think the market is going down."
In most instances, buying a call option is speculative. When you buy a call option for a stock, you are buying the right to purchase that stock at a set higher price in the future because you believe it will go higher than the strike price agreed on in the contract.
If you purchase a call option to buy 'stock X' at $45 a share within the next six months, and the current price is $40, you would be able to purchase the stock for $45 even if it goes up to $50 three weeks after you purchase the contract.
In that instance, you would save $5 a share if you exercised the call option contract to buy that stock for $45 even though it trades at $50.
When many investors use options on their own, they tend to buy call options because they can purchase the contract for a small fraction of the cost of the stock, hoping to hit a home run.
"They usually buy options that are far out of the money, meaning that if a stock's price is at $10, they're going to buy a call to purchase the stock if it hits $20 and goes higher," Derwin says. "They look at it and think, 'For 10 cents a share, I can get all these options,' but the odds of the stock hitting that price are slim to none."
But when investors sell call options, contracts that give the right to someone else to buy their stock at a set higher price in the future, they often do so to earn money from selling the contract, to lock in future capital gains and to protect against the stock's price from going down.
"By selling a call, it allows you to turn an unknown, potential return into a certain return," says Alan Fustey, a chartered financial analyst with Elysium Wealth Management in Winnipeg.
"You know that if you're selling this call, you're at least getting the premium paid by the buyer of the call, no matter what happens."
If you sell a call option for $2 a share on a stock worth $50, where you would be obligated to sell your stock if it hits a strike price of $55, you would have to sell it for $55 even if it hits $60 over the term of the option contract.
But for the most part, call-option contracts never hit their strike price and they expire without being exercised by the buyers.
"If that's the case, and if you're buying a call option, the odds are working against you," Fustey says.
And if you're selling the call option, it means you generally collect the premium from selling the contract without having to sell the stock. Even if the stock drops in price, you still earn the premium from selling the call-option contract, which helps soften the downside.
"Let's say the stock, once at $50, goes down to $43 a share," Fustey says. "You still get $2 to offset the loss, plus you get to keep any dividends because the call option won't be exercised by the buyer — you hold onto the stock."
On the other side of the equation is the put option, which a stockholder will buy to protect against the stock dropping in price.
"If you're holding onto stock in anticipation of a bad earnings announcement, you might just buy a put option in order to unload the stock at a set price if the news is really bad and the stock crashes," says Rob Hall, a Winnipeg-based market strategist, who writes on the online investment analysis newsletter The Hall Report.
Buying put options is like buying insurance for your home. You pay a premium — usually about five to 10 per cent of the stock price depending on the length of the contract — to sell your stock at a set price.
If the stock drops below that price, you can exercise the contract and the investor who sold the contract and collected the premium must buy stock at the agreed price, even though its real market price could be much lower.
"It's like you pay a premium for insurance in case your house burns down so you get the cash payment," Fustey says about buying a put option. "If your house doesn't burn down, you've given away money paying for the premium."
On the flip side, the seller of the put option collects the premium and then has the obligation to buy that stock if it drops below the agreed price. Derwin says many put-option sellers employ a "get paid to wait" strategy on a stock they would like to purchase.
"We'll sell a put option to someone on a stock because it is a company we would like to own," he says. "And the put option would allow us to own it at a 10 per cent discount and get paid to do it by collecting the put's premium."
Although buying and selling options are proven strategies to create income, manage stock-price fluctuations or speculate on price movements, most mutual fund investors are unaware of options' role in the financial realm. And that's because it's unlikely they'd ever need to use them.
"Options aren't for everybody," Derwin says, adding only two per cent of Canadian investors use options. Most people who do use options successfully are helped by an adviser and they typically have portfolios of $250,000 or more. But with more investors moving away from mutual funds to ETFs, it's helpful to understand how options can enhance returns.
"You can get exposure to stocks through purchasing a related ETF and you can sell calls on it to generate your own dividend-type income stream," Derwin says, offering up an example stock/option strategy.
And even if you never use them, at least the next time you're at a party you'll have a clue of what that wealthy blowhard is talking about when he says he made a killing in the options market.