How Useful Are The Options To Protect Your Portfolio?
The estimated volume of derivative market is more than $1.2 quadrillion, it is gigantic, even compared to the total market capitalization of SP500, ca. $20trillion. The idea behind the derivatives was to transfer the risk associated with the market price of an underlying asset. Can investors use the derivatives to reduce the portfolio volatility or limit their downside risk?
The options are alternatives to stop-loss. They don’t have a price limit to terminate the position but an expiration date and also a premium as a price because the writer of the option receives a premium for taking the risk for the adverse price movement. And the premium is calculated according to Black-Scholes Model which should reflect the risk or the expected loss in case of adverse price movement.
The derivative market protects some companies from the real economy against price fluctuations in commodity or foreign exchange markets and there are a lot of commodity producing companies which use the futures as an insurance against the price decline.
Using derivatives to hedge against price volatility:
If you look at the financial reports of oil producers you will notice that they are protecting themselves against price declines by selling futures in derivative markets. Some times, they make losses and some times they make profits from the derivative business. But nevertheless, in average, they are benefiting from the derivatives which really protects them.
Suppose there is an oil company producing crude oil with a cost of $40/barrel and the company sells a future contract on date x with a price of $100. By selling this future contract, the company has a guarantee of a $60 per barrel profit but it has also the obligation to deliver the crude oil on the date x. Therefore, the company traded the risk of price with the risk of delivery.
And the buyers of the futures are usually the companies using commodities in their production and want to lock the price until a certain date, similar to sellers.
Suppose the spot price of oil on date x is $90, in this case, seller makes $10 profit from the derivative business which neutralizes the loss of $10 in the crude oil’s real spot market on date x. And the buyer of the future makes $10 loss from the derivative business which will be transferred to the seller and will be compensated by $10 cheaper oil in the spot market on date x. At the end, neither buyers or sellers make a profit or a loss, all profits and losses are neutralized. And you will notice in their financial reports that they are never using derivatives to speculate but only to protect themselves against price fluctuations.
The real benefit of sellers and buyers of futures is that they can lock the price until date x in order to gain time to adapt their businesses to price fluctuations.
In the example above, the seller, the oil producing company, gets the insurance against the falling oil price but gives the guarantee to deliver the oil on date x at the price of $100. And the buyer, for example, a refinery, gets the insurance against rising price but gives the guarantee to buy the oil on date x at the price of $100. Of course, the process is not that simple but the main issue here is that the buyer and seller can offer an insurance to each other and protect themselves. This is the fundament of the derivative market.
The derivative market offers short term protection against price fluctuations in order to give time to the companies to adjust their production. Sooner or later, all participants are affected by price changes: if the oil price goes down the oil producers have to curb their production because they would have fewer oil resources which are economically feasible at the new low oil price.
The role of traders in the derivative market:
Suppose a trader buys the future contract from the oil producer. In this case, the trader replaces the refinery’s place and he gives a price guarantee to the oil supplier without any interest in actual delivery.
If the price goes up, say $10, the trader makes $10 profit which would not be neutralized. For the selling oil company, all remains the same.
The trader who doesn’t participate in the production of goods has the opportunity to profit because he has also the risk of loss. His profits or losses will never be neutralized like corporations of the real economy, as explained above.
Therefore, the idea that the traders can have a guarantee of profit or a protection from losses is absurd. There can not be some instruments, i. g. options or some trading strategies guarantee to profit unless there are unfairness or irrationalities in the market regulations.
The statement above contradicts the efficient market hypothesis and we will see it in the next chapter.
related article: The Myth of Efficient Markets
The real cost of options:
As mentioned above, the premium of options is calculated according to the Black-Scholes Model (BSM) which is a product of efficient market hypothesis (EMH).
According to EMH, the markets are efficient enough to process all available information in the most rational way possible. Therefore the price fluctuations are caused by random events that cannot be predicted. Because of randomness, price volatility would show a normal distribution around the value of the underlying asset. And the BSM calculates the premium of an option under the assumptions of EMH as an expected loss.
It is like a car insurance: the insurance company calculates the risk of accidents you will have, the possible costs to cover and then the expected loss on your insurance. Your insurance premium is the addition of expected loss and profit of the company.
If EMH is right the trader can buy call option instead of a future contract and his expected profit after cost of premium would be the appreciation of the underlying asset’s value.
For example, if he buys one weekly call option of crude oil every week, after one year, he would have bought 52 options and should expect the same return as if he invested in oil. This means: if the crude oil’s price rose 10% then the trader’s total profit after one year would be ca. 10%. But it is very likely that he would ruin his capital.
Or, suppose the trader randomly buys 300 call options of different companies listed in SP500 and the options have the expiration time of one year. In this case, according to EMH, he can expect the same return of SP500. But eventually, he will lose more than 90% of his capital even if SP500 gains 20% in value.
If the majority of the options burn their premium and in total, the options make losses what is their use for?
Generally, the options are expensive but a small percentage of them are cheap because EMH is wrong and the market has irrationalities, inefficiencies, and also unfairness. The trader has to find the cheap options.
For example, after the announcement of quantitative easing QE, a lot of traders bought call options which’s prices don’t react to QE announcement (BSM). The extern influence of FED made some call options cheap.
And some participants of the derivative market: the corporations of the real economy, for example, oil producers or refineries like in the example above, don’t speculate or trade on news like QE announcement when they buy or sell derivatives. And by doing so, they give profit opportunities to traders.
How traders make a profit with options:
As mentioned before,
in a derivative market, neither a trader or an investor can have a guarantee for a profit unless the market is unfairly regulated, like the “Bernanke Put”. The opportunities to profit can come from irrationalities, inefficiencies, distribution of market balance by extern influences and unfairness but not from thin air just by applying some options strategies.
And there are also some arbitrage opportunities because of the participants’ different motives: i. g. commodity traders vs commodity producers.
And the options are irrational products because EMH is wrong. But they don’t provide the opportunities, the opportunities can come from irrationalities, i. g. herd mentality. The only benefit of options is maximising the chance – risk ratio, nothing more.
If a trader tries to reduce downside risk only with option strategies he has to also reduce the upside potential of the trade. And if he eliminates the risk he would also eliminate the chance. For the producers of the underlying assets, like oil company in the previous example, this is not a problem because they don’t want to profit from the derivative market but from the production.
Derivatives don’t make the market irrational but can exaggerate the already existing irrationality in the market and by doing so, they make themselves more demanded by the traders. And this self-feeding positive feedback cycle is one of the reasons for the growing gigantic derivative market which has surpassed the total value of its underlying assets.
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