Derivative Duels

By James H. Nolt

Many of the most successful investors leverage their own capital with borrowed wealth to magnify their profits. Capital they own is supplemented by capital they owe to creditors. Strong use of leverage is a characteristic of bulls. Many financial crises occur when the most leveraged bull positions are undone, typically when creditors become bearish.

Throughout the history of securities markets, a popular way to pump up demand for a stock and thus its price is to offer to finance the sale. Either a broker or other promoter, such as the investment bank that handled the IPO of a new stock, will offer creditworthy customers the option to buy “on the margin.” In other words, they need to pay only a small fraction of the price of the stock, say 10 percent up front. The remaining 90 percent might be paid in installments over a period of months or years.

Thus, if an investor has $1000 to buy stock and the issue price is $100, he could only buy 10 shares, but if the promoter offers to finance 90 percent of the price, he can buy 100 shares instead. This is a very bullish move. If the price goes higher, his gains are magnified ten times. But if it falls more than 10 percent (assuming that is all he has paid in so far), his entire investment stake ($1000) is wiped out, even if he sells the stock to staunch further losses. If many leveraged investors are trying to sell at the same time when a high-flying stock suddenly turns down, the result is a bubble bursting.

Examples of this kind of leveraged stock purchasing leading to a bubble then a crash are rather common. Some spectacular examples include the twin Mississippi and South Sea bubbles of 1719-20 and the great stock market crash of 1929. But do not think this is a thing of the past.

During recent decades the enormous expansion of derivatives trading has made almost every form of asset worldwide subject to this form of leveraged betting. The face value of all derivatives contracts in the world at the time of the 2008 financial crisis was estimated at around $600 trillion! Today the figure is bigger; probably over $1 quadrillion. Derivatives contracts now dwarf stock and bond contracts by several times over. This means, broadly speaking, that more investors are betting on the future prices of things rather than actually owning them.

I am often incensed when the media shrugs their shoulders at derivatives and claim they are too complicated to explain to the general public. Actually, many important things about them are quite simple. Financial derivatives, like stocks, bonds, bills, and other financial instruments, are merely contracts with a value. But whereas owning a bond or a bill means owning a debt claim, owning a derivative contract means owning a bet about the future value of something, which is called the underlying.

The underlying can be anything two parties to the contract agree on, but the most common derivatives are bets on the future price of a specific stock, bond, commodity, or currency.

The contract specifies a price, called the strike price, for a certain specified quantity of the underlying, say, $50 per share for 1000 shares of GE common stock or $150 per barrel for 10,000 barrels of crude oil. There are two directions you can bet: that the price will go up or go down.

There are three main kinds of derivatives: options, futures, and swaps, but for this column we will consider only the first two. Options are an option to either sell (put) or buy (call) the underlying at the strike price by (American) or on (European) the maturity date specified on the contract. The maturity date can be any date, but typically within a few months of the issue date. Futures are promises to sell (short) or buy (long) the underlying by/on the maturity date.

Now here is the important point often underappreciated: every derivative contract has two sides—the one who owns the contract owns the bet. The one who issues the contract owns the other side of the bet. The loser pays the winner. Either party may subsequently sell their side of the bet to another investor. Regarding the underlying, one side is a bear; the other side is a bull.

Because every bet has two sides, there will always equally be a winner and a loser. In this way derivatives differ from most other financial contracts. Furthermore, the more volatile prices are, the more derivatives cost and the more money changes hands when the bets are settled. Derivatives thrive from instability.

Broadly speaking there are two possible strategies using derivatives: hedging and speculation. Hedging is the strategy most often advertised by those claiming derivatives improve safety and stability. A hedge is like insurance. If you own something, you can use derivatives to hedge against what you own losing value.

Consider an example. If Exxon has 100,000 barrels of oil on a tanker traveling from Kuwait to New Jersey, the company might wish to hedge against possible losses if the value of the oil falls while the tanker is at sea for the two-month trip. Suppose at the time it sails, the price of oil is $100 a barrel. The company could buy a put option on 100,000 barrels at a strike price of $100 a barrel with a two-month maturity. This effectively locks in the price. If the market price falls to $90, Exxon still has the option to sell the oil at $100 when the two-month voyage is done. The difference of $10 per barrel is paid by the issuer. If the price goes up, Exxon profits, but if the price goes down, it does not lose.

Of course derivatives, like insurance, are not free. Typically they might cost a percent or two of the face value, adding a bit to costs. The more volatile the price of the underlying, the more expensive derivatives become. It is safe to bet on the price of something that changes little, but unsafe if it changes a lot, so the issuer will demand a higher price if there is a bigger risk of losing. The price also varies a lot if the strike price is different than the current market price of the underlying. In this case, if the price of oil goes up, Exxon’s put option is useless, but the issuer still gains the price Exxon paid for the contract and Exxon sells the oil for a gain, minus the cost of the option.

Hedging is the safest use of derivatives, but even it poses a risk for the other side, the counterparty to the contract. The larger the price movement, the greater one side gains and the other loses. Next week we consider how derivatives give speculators potent powers to leverage profits and to set up rigged games.



James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photos courtesy of Wikipedia and Baoreview]

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