Derivatives - Not the spawn of Satan for Investors?? An example

Perhaps it will be necessary to choose my words here with an unaccustomed caution. Why? - Because I am going to think about derivatives and their place in the world of investment. Even more radically, I am going to suggest that they are not out of the reach or understanding of even a small investor.

At the height of the banking crisis it got a little interesting being an investment banker. I seemed to wear a permanent fixed and brittle smile as every cocktail-party pundit and bulletin-board guru delighted in comparing the banking world with the nether regions beyond the Styx. When I ran into the totally delightful rector of my local church here and saw him bearing down upon me, my immediate reaction was to duck into a doorway in case he was going to perform an impromptu exorcism to drive out the demons of derivatives from my soul.

For the sake of clarification, "Derivatives" is a slippery term. It encompasses a number of different worlds. Some of the very complex structures are the exclusive domain of the interbank (or at the very most  inter-institutional) market. The highly-geared products based on Debt can range from the  relatively secure such as government bonds to the truly terrifying such as US sub-prime mortgages. I don't want to re-open the whole can of worms, but the repackaging of the latter, often  into structures so complex as to be not easily or fully understood by even the experts (and often with at least one more level of gearing) was the nightmare that led us to Lehmans & Bear Stearns. On the back of that (always there but the tide went out and the other mistakes were uncovered) we got the same sort of structures in Credit Default Swaps - derivatives on the credit-worthiness of corporates and even governments.

None of these risky derivatives were inherently evil - it is worth bearing in mind that all modern structures of this sort have their roots in an idea first put into action in Osaka in the 1630's - as a form of financial insurance against something going wrong (in that case a failure of the Rice harvest). These more recent structures were a way of lenders being able to protect themselves against their mortgages going wrong by buying insurance or hedging. Similarly Credit Derivatives enabled not just lenders, but even major corporate customers to gain some sort of cover (and incidentally led to a far more flexible view of credit rating than the major agencies were able to supply under pressure). The problem lay in the fact that these products were traded and re-packaged so many times that the underlying risks were multiplied as ever more layers of obfuscation and gearing were added, rather like a game of pass-the-parcel in reverse.

All that is background, however, to the truly vast daily activity that happens in derivatives daily. Rather like an iceberg, the vast majority of activity is submerged and not readily visible. This inter-dealer and inter-bank business is only partly visible on exchanges, as most of it is by private deals - usually described as Over-The-Counter or OTC transactions. Even so, a massive amount of derivative business is transacted every day on regulated exchanges all over the world - in Stocks, Bonds, Equity Indices, Currencies, Energy, Foodstuffs, Metals (both common and precious) and a wide range of seemingly esoteric other markets. Most of these are accessible to the private investor.

When I first came into the financial world the concept of Caveat Emptor was regarded as regulation enough, but with the onset of more formal regulations came the risk warnings that have stifled the growth of some areas. This is not to say that any geared investment should not be regarded as worthy of great caution, but my experience tells me that more so-called experienced investors under-estimate risks than many cautious "amateurs".

I want to illustrate an example of how this might work with a transaction that a close friend recently made. It is all the more interesting because, firstly it was based on a wrong premise - he thought Stock Markets would decline - and secondly because it shows how derivatives (in this case options on a stock index - the FTSE 100 index) can be used to control exposure rather than to increase it.

The FTSE 100 index can be accessed in a number of ways. Tracker Funds such as iShares can be bought for a few pounds. The FTSE futures contract is a bigger bet - at ten times the index, around £59,000 - but the private investor normally only puts up 5% to 10% of that total amount - this is usually called his "margin". The investor gets exposure to £59,000 of index for, say £5000. At an index of 6400 (up 8.4%) he doubles his money. At 5400 he has lost 100% (and is at risk for more if it continues to go down). Simply speculation if you would not normally have bought a £59,000 chunk of stocks - highly efficient investing if you would.

Now to get one level more complex. The trade my chum made (and he is an experienced investor) was just plain wrong. He thought the FTSE would drop in October (a seasonal trade I have never felt comfortable with even if some of the big moves down were made in that month). He sold FTSE futures at 5675  - almost 135 points to the wrong and thus sitting on a loss of £1350. Disaster? Nope - because he simultaneously sold a one month maturity Put Option for 108 points. This option gave the buyer the right  (but not the obligation) to any profit from selling at 5675 in return for a one-off payment of the 108 point premium.

Good trade? Well no actually, because when the option expired, although my chum took the 108 point premium, the FTSE had gone up by 150 points. Disaster? Another no - because he sold another option for one month to someone wanting to get the profit if the market collapsed below 5675. This time he only got 64 points as the potential for the buyer was less. Let's do the sums.

Short FTSE @ 5675
Sell 1month 5675 Put Option @108
End of month price 5808
Open Loss on FTSE (5808-5675) = 134
Less Premium Received (-134+108) Net Open Loss -26 points (Equating to £260 in real money)

After first option expires
Still Short FTSE @ 5675
Sell another 1month 5675 Put Option @ 64
Current price 5806
Open loss on FTSE (5806-5675) = 131
Less first Premium Received and second Premium Received (-131+108+64) = Net Open Profit 41 points (£410).

I will not insult anyone's intelligence by iterating further - but I think it become obvious that a bad call initially seem to be turning into a good trade.

If the market is at or below 5675 at any option expiry then he gives away any profit on his FTSE short to the lucky buyer of the put option but gets to keep all Option premia obtained in the first two and any subsequent monthly cycle. In the case above he would have got 108+64 points in total, equating to £1720 - a return of 2.91% on the full index and 34.4% if a deposit of £5,000 was made. Not bad for two months. To look at the worst-case scenario, the FTSE could continue to rise and the the loss on the short position with it. Each month a further sale of a 5675 Put would mitigate that however and if, as my chum fervently believes (I really am not sure I agree with him) the market reaches 5675 again he will be sitting on a tidy profit.. The idea is that the option premia rack up each month until the 5675 level is hit again - if it ever is.

There are complexities such as rollover costs (the futures are on a 3-monthly cycle) and commissions - but these are not significant.

So - there is an example of a derivative trade that does not involve a little old lady being evicted from her home due to the failure of her sub-prime mortgage bank, does not involve Gordon Brown loading debt on our children and grandchildren. Instead it is a rather interesting way of taking a view on the market going down - which might be seen as insurance against the Pension Pot in some quarters?

I will update regularly on this one

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