A guide to pricing and hedging (2003) [pdf]
ieor.columbia.edu
ieor.columbia.edu
For example: Your tech startup was purchased by a large public company, and you end up with stock you cannot sell for, say, 3yrs.
You are not an insider and now just retired and have no insider info and you dont have restrictions on puts -- In this situation, you can hedge your downside. You can also do a zero-cost collar and hedge your downside funded by giving up your upside.
But the option strategy is much riskier as a loss of -100% is significantly more likely under the put option than the short due to implied leverage, time value decay, etc.
1) Derivatives allow you to tailor your risk to the precise component of the market that you have a view on. If you think the stock is going to have a large move (either up or down) in the short term, it's tough to express that view in the stock. If you buy stock, you lose money on a down move. If you sell short, you lose money on an up move. So, you can buy short-dated put and call options together (nicknamed a "straddle" if they have the same exercise price, and a "strangle" if the put exercise price is less than that of the call) and you capture not only your view on what the stock is going to do, but also the timeframe in which you expect that move to happen.
2) Options cost less than stock, so you can lever your position. Let's say a stock trades at 100 and you want to buy a hundred shares. Ignoring interest, that position costs you 10,000 dollars. If it rallies to 110, you make 1,000 dollars, or ten percent of your capital outlay. But if you buy a contract of 50-strike calls, you pay around 5,000. If the stock rallies to 110, you make 1,000 dollars again, but that is 20% of your capital outlay.
3) Derivatives have more factors involved in the valuation, which makes them complicated. This is a battleground where smart people who are willing to work hard can find inefficiencies and make money. Stocks have more people looking at them, and are more simple, so they may not offer the same opportunities for profit depending on your skillset.
4) Options serve a tax purpose. If you have a long stock position that you have held for six months and profited from, but the company has earnings and you don't want to risk losing money on a potentially bad quarter, you could sell your stock and pay short-term capital gains tax. Or, you could sell calls to buy puts and maintain your stock without having to pay tax on your stock gains yet. If the difference between long- and short-term capital gains tax is greater than the cost of the options you buy, then you could be saving money.
Amazing to me that the "why is the title gender normative" comment has gotten traction, but you've been downvoted. The internet is strange.
I had a similar problem during an IPO lockup and couldn't sell when the stock was at a high point. If you buy protective puts (for the collar), it would reset the long term capital gains clock on your long position. I would love to be wrong so I can regret/cry about it!
Yes, this is true.
However, it doesn't force you to pay taxes at the higher rate, only to wait longer before the lower rate applies. Once you dispose of the put, the clock resets. But if you continue holding the stock for greater than a year, then the only issue is that your dividends may be taxed more.
On a large-cap name, one thing that some people do is to use a well-correlated index or competitor for the hedge.
In your lockup, I'm betting there were some restrictions on hedging anyway, which may have prevented you from buying puts at all.
Options make certain things tradable that were not previously tradable. As you already say, given only the spot, you can basically trade delta - will it go up or down. With options, you can trade vol - will it move little or a lot. With a basket of options versus an option on a basket you can trade correlation - will things move together or not. With CDS you can trade credit (separately from interest) - will a firm go bust or not.
And creating these markets allows for more informed opinion on what's going on.
Having said that, I think derivatives are overrated and fulfil few socially useful functions, and those are often fulfilled by the simplest derivatives, not the complex stuff banks like to peddle (because their fees are higher, yet hidden).
https://en.wikipedia.org/wiki/Option_(finance)#Historical_us...
It’s true that if you’re a small individual investor you don’t have much use for derivatives; you probably don’t have idiosyncratic risks in your portfolio you need to hedge away. But businesses and big institutional investors do.
A simple example is a corporation that buys goods in China and sells them in the US. This corporation does not want to lose money due to a poor USD/Yuan exchange rate, so they hedge that risk by buying a financial instrument that guarantees them a certain USD/Yuan exchange rate.
Does the average Joe ever need to hedge currency risk? No. But large institutions do. And this is just a single risk; hedging is not just used for exchange rate risk, but also for credit risk, interest rate risk, asset price risk, liquidity risk, disaster risk, political risk, and so on. Any kind of risk can be priced (see for instance, health insurance and car insurance for consumers, a mechanism by which large corporations price the bulk of consumer risk), and there are many trillions of dollars that belong to groups that especially dislike certain risks, and therefore wish to hedge them.
In the months between finalizing a price and receiving the cash, you're exposed to foreign exchange risk. If CAD goes down, you end up making more money "for free", but if CAD goes up you make less. In the long run, you expect these currency fluctuations to average out; the unexpected surpluses will go towards covering unexpected losses.
Now let's look at a financial engineering trick that can eliminate this currency risk. Let's say you buy some `call` options, and sell some `put` options on a CAD/USD fund. (Selling the puts covers the cost of buying the calls). Now, if CAD goes up--which is normally bad for you--the value of your call options also goes up and cancels out your losses on the shipment. If CAD goes down--which is normally good for you--the puts that you've sold grow in value and must be settled with the buyer, so this cancels out the surplus you made on the shipment. The net result is that the amount of CAD you expect to receive two months after signing a contract in USD is "locked in" based on the exchange rate at the exact time you signed the contract and simultaneously bought the options.
So far, both the naked method and the "hedged" method result in the same expected profit in the long run. But notice that in the hedged case, you don't need to carry extra cash on hand just in case your company is hit with 3/4/5+ bad orders in a row. You don't need an insurance policy, you don't need to carry debt, and you don't need to pay the interest associated with either of those. You might still need some extra cash lying around to cover for other unexpected risks like labor strikes, natural disasters, whatever, but not for currency risk. This money is now freed up and you can use it to build new factories and grow your operation. You've made your business more efficient without lifting a finger!
Now the beautiful thing is that on the other end of this options deal there's going to be someone selling calls and buying puts that has the exact opposite problem you have. Maybe an importer in Canada or an exporter in America who both benefit from a rising CAD. They too get to lock in a price and avoid carrying extra cash to cover for currency risk. You both ended up helping each other without having to expend any effort finding the other party, negotiating deals, etc.
Now think how much more efficient the economy gets when everyone does this. And this is just one technique.
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Regarding personal investment, you can likewise use hedges, levers, and other financial instruments to come up with a risk/reward profile that matches your particular life situation. As a very simple example, you can buy a "protective put" option at say 80% of the price of equity A. This basically acts as an insurance policy; you spend a bit of money on the put, but now you're guaranteed to not lose more than 20% of your investment. Why not just keep 80% of your money in a bank account and invest 20%? Well, to make the same return you'd have to find an equity B that's expected to return 5x what you're expecting from equity A, and that might not exist.
As an example, Mark Cuban used put&call options to lower the stakes of the roulette wheel.[0]
He sold his startup to Yahoo for ~$1.4 billion of stock (1999 stock price was ~$95) -- but he couldn't sell it immediately because it was locked up for 3 years. That's a long time for Yahoo stock to potentially double... or go all the way down to $0.
To protect his wealth and get around the lockup, he bought put options to limit his downside. He also sold a matching set of call options to offset the out-of-pocket costs of buying the expensive puts. Therefore, deliberately limiting his upside was the proverbial "price to pay" to protect his downside. His financial engineering reduced the vagaries of the volatile stock roulette wheel.
It turned out that not getting too greedy with a potential gains and worrying more about the potential losses was a smart move because as we now know, the 2000 Dot Com Crash happened and the 2002 Yahoo stock price plunged to just $8: https://www.theatlas.com/charts/B1RjK9Q_
[0] https://www.acceleratedfi.com/real-world-options-example-how...
Thank you!
[0] https://www.amazon.com/Options-Futures-Other-Derivatives-10t...
"If you want to know the value of a security, use the price of another security that's as similar to it as possible. All the rest is modelling. Go and build."
Buffett:
"Price is what you pay; value is what you get."[a]
--
If you're balancing an options portfolio, on the other hand, shorter time horizons matter. If the stock pays back in 10 years but crashes in one, the ten years don't matter for the holder of a 12-month call option. Thus finding symmetries becomes more relevant than fundamental analysis.
Arguably, one could call the long-horizon, volatility-ignoring approach "investing" and the short-horizon, volatility-sensitive approach "trading."
Here's his book. I haven't read it but it's probably interesting.
https://www.amazon.com/My-Life-Quant-Reflections-Physics/dp/...
A bit off topic anecdote: a few years ago, while floor trading was still important on the Chicago Board of Trade, I was getting a tour of the floor during trading hours and my guide, a very experienced commodity trader, pointed out a fellow trader that had made the largest trade in history; it was a woman.
I bet that many women reading this title that work in finance don't appreciate the title one bit.
The argument that it's just a joke is not acceptable, because this together with other 1000 similar remarks, or "jokes" or micro-agressions will make women choosing that field as inadequate over time.
This is actually a scientific fact, that people that are told several times that they are not able to do a task or don't belong performing the task will underperform doing that same task, when compared to people that are not subjected to that treatment.
Words are powerful, I wouldn't want my two daughters to put up with this type of bullshit growing up.
But I agree with your underlying point. At best the title is careless and lends itself to misinterpretation.
(Worth noting, perhaps, that the linked paper was published in 2002. I wonder if the author would have thought twice in 2019?)
It implicitly conveys the message that women don't belong in Finance. I don't see how anyone could attempt at denying that or try to defend it.
I should be happy for free speech, what does that even mean LOL?
Complaining about the little things can hurt the bigger cause if you piss people off in the process.
But if you start looking with fresh eyes you start to see again and again and again small things, apparently insignificant things, that all combine to say "Women aren't welcome here." This is a single, simple, tiny, apparently insignificant example, but it's utterly ubiquitous.
Your dismissal just makes it clear that you either haven't noticed, or don't care. It's a sobering thing to realise that there is just so much subliminal repelling of women from fields such as finance, programming, physics, mathematics, engineering, and more. If you start to listen to women instead of just saying "it's all in your head" then you'll learn something.
And it's horrifying. I always feel guilty that when I get tired of the fight I can give up for a while. But that's because I'm a cis-het white male, and the system is biased in my favour. Others can't choose to give up - and it's relentless.
What is exactly the perspective that looks at the title of this article and thinks its perfectly OK?