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Agenda
An Introduction to Derivatives
Types of Derivatives Call Options Put Options Options Resources
What is a derivative?
A financial instrument that derives its value from the price of an underlying asset For example, if I have a cow, and sell you the right to its meat once it goes the slaughterhouse, the cow meat is the underlying asset and the contract itself is a the derivative Key concept: a change in the underlying price of the asset changes the price of the derivative itself (ex. Cow meat goes up in value, someone will be willing to buy the rights to the meat for more)
Derivative Markets
Options
Futures
Swaps
Futures Example
I own a corn field that produces 100 tons of corn each season. I am approached by a buyer who offers to buy my corn for $750/ton when its trading at $800 now. Since I am unsure of what the price of corn will be 3 months from now when I harvest it and try to sell it, I take the deal
Futures Example
Along comes harvest day and the price of corn has changed. Now corn is trading at $850/ton due to larger than expected demand. Since I am contractually obligated to sell my corn at $750/ton, I sell the corn for $750, losing out on an extra $100 per ton. The person who bought my corn buys it from me for the agreed upon $750, then turns around and sells it immediately at the market price of $850, making a $100/ton profit.
Why?
Why would I enter this futures contract? I ended up losing out on $100 and even sold my corn at below market price when I issued the contract for $750 instead of $800.
UNCERTAINTY! By giving away the potential upside, I am protecting myself from the downside risk of corns price falling.
Futures Trading
Once you own a futures contract, you can trade it to another person, giving them the right to collect the underlying asset at the fixed price. So when the price of the commodity increases and you have a futures contract to buy for less, people are willing to buy your contract
Agriculture
Corn, wheat, cotton, coffee, sugar
Livestock
Cows, chickens, hogs
Metals
Gold, silver, copper, platinum
Futures Reviews
Futures are contracts where one party agrees to purchase some asset at a fixed price in the future.
The selling party will sell a futures contract if it expects price to be uncertain, drop, or if the current price is good The buying party will buy a futures contract if it expects price to increase in the future
Derivative Markets
Options
Futures
Swaps
Swaps
A derivative where two or more parties exchange cash flows in return for security against default on payments Credit Default Swaps Interest Rate Swaps
CDS Trading
AIG can then turn around and trade the CDS on a swap market. If Greece increased its ability to pay back the debt, the value of the CDS goes up. Since the CDS was issued for a certain risk level and determined its cut of the interest based on that risk level, and now the risk level is lower, but the cut is the same, the CDS is generating more return for the current risk. This makes the CDS more valuable. AIG can then sell the CDS for a profit.
CDS Trading
If Greece becomes more unstable, the chance of default increases. Since the CDS was issued for a certain risk level and determined its cut of the interest based on that risk level, and now the risk level is higher, but the cut is the same, the CDS is not generating enough return for the current risk. This makes the CDS less valuable. AIG would have significant difficulty selling this CDS for a profit
Swaps Conclusion
In essence, swaps deal with cash flows being exchanged between two parties, with a third party stepping in to limit the variability and risk of the cash flows.
The issuer of the CDS (the insurer) is betting on the company to not default and to pay out all the interest payments. The person receiving interest payments buys a CDS to protect against risk of default The company paying out interest has no direct stake in the CDS
Derivative Markets
Options
Futures
Swaps
An Option Walkthrough
Date is currently Friday, Feb 22. CAT is currently trading at $100 per share. I expect that CAT will increase in price between now and Friday, Mar 8 because its earnings report comes out on Mar 5. I could buy 100 shares of CAT for $10,000, or I could use options.
Options Markets
Options are the right to buy a security at a fixed strike price for a certain amount of time. Some definitions:
Strike Price- the price your options contract says you can buy 100 shares for In-the-money- when the strike price of the option is below market price of the shares Out-of-the-money- when strike price is above the current share price Expiration Date- the last day you can exercise the option before it expires
Options
When you are looking to use options, the first step is buying the option
Options have listed prices based on their strike price, volatility of the underlying stock, time until maturity, etc. The price thats listed is not the real price! Since options are rights to buy 100 shares, you have to multiply the option price by 100. In essence, the option price + strike price is the minimum share price the stock must trade at in order to make a profit
Options Example
Option Cost $31 $24 $18 $6 $.85 $.02 $.01 Strike Price $85 $90 $95 $100 $105 $110 $115 Price stock has to be in order to make a profit (cost + strike price) $116 $114 $113 In the money $105 Out of the money $105.85 $110.02 $115.01 Note how as you get deeper in the money, and the risk that your strike price is less than market price declines, you have to pay more for the option, and thus, actually have to have a higher share price to make a profit.
Note how the cost of the option + share price is greater than the current share price This prevents people from just buying the inthe-money options, exercising them immediately, and making instant profit
If you simply bought 100 shares of the stock for $100 each, then sold at $125, you would have made: Profit = $2500 = 25% return
Investment = $10,000
Put Options
Put Options are options that allow you to SELL a stock at a given strike price.
Use put options when you think that a stock is going to decline in value before the expiration date.
On another end, the person who writes the put option and sells it to you is offering to buy 100 shares of the underlying stock from you at a fixed price
Options Strategies
Investors combine different options together with different strike prices in order to provide different protections from volatility and allow them to make large profits in any situation, provided the strategy is structured correctly. A number of websites have strategies listed:
Optionsplaybook.com has great illustrations of how to set up different strategies, where you make profit, what you are betting on, etc.