http://valuationacademy.com Introduction to Derivatives — Valuation Academy

Introduction to Derivatives

Long vs. Short

Being “Long” something means you own it. Being “Short” something means you have created an obligation that you have sold to someone else.

If I am long 100 shares of AAPL, that means that I possess 100 shares of AAPL. If I am short 100 shares of AAPL, that means that my broker let me borrow 100 shares of AAPL, and I chose to sell them. While I am short 100 shares of AAPL, I owe 100 shares of AAPL to my broker whenever he demands them back. Until he demands them back, I owe interest on the value of those 100 shares. You short a stock when you feel it is about to drop in price.

The idea there is that if AAPL is at $50 and I short it, I borrow 100 shares from my broker and sell for $5000. If AAPL falls to $48 the next day, I buy back the 100 shares and give them back to my broker. I pocket the difference ($50 – $48 = $2/share x 100 shares = $200), minus interest owed.

Call and Put options

People manage the risk of owning a stock or speculate on the future move of a stock by buying and selling calls and puts.

Call and Put options have 3 important components. The stock symbol they are actionable against (AAPL in this case), the “strike price” – $52 in this case, and an expiration, June.

If you buy a AAPL June $52 Call, you are buying the right to purchase AAPL stock before June options expiration (3rd Saturday of the month). They are priced per share (let’s say this one cost $0.10/share), and sold in 100 share blocks called a “contract”. If you buy 1 AAPL June $52 call in this scenario, it would cost you 100 shares x $0.10/share = $10.

If you own this call and the stock spikes to $56 before June, you may exercise your right to purchase this stock (for $52), then immediately sell the stock (at the current price of $56) for a profit of $4 / share ($400 in this case), minus commissions. This is an overly simplified view of this transaction, as this rarely happens, but I have explained it so you understand the value of the option. Typically the exercise of the option is not used, but the option is sold to another party for an equivalent value.

You can also sell a Call. Let’s say you own 100 shares of AAPL and you would like to make an extra $0.10 a share because you DON’T think the stock price will be up to $52/share by the end of June. So you go to your online brokerage and sell one contract, and receive the $0.10 premium per share, being $10. If the end of June comes and nobody exercises the option you sold, you get to keep the $10 as pure profit (minus commission)! If they do exercise their option, your broker makes you sell your 100 shares of AAPL to that party for the $52 price. If the stock shot up to $56, you don’t get to gain from that price move, as you have already committed to selling it to somebody at the $52 price.

Again, this exercise scenario is overly simplified, but you should understand the process.

A Put is the opposite of a Call. If you own 100 shares of AAPL, and you fear a fall in price, you may buy a PUT with a strike price at your threshold of pain. You might buy a $48 June AAPL Put because you fear the stock falling before June. If the stock does fall below the $48, you are guaranteed that somebody will buy yours at $48, limiting your loss. You will have paid a premium for this right (maybe $0.52/share for example). If the stock never gets down to $48 at the end of June, your option to sell is then worthless, as who would sell their stock at $48 when the market will pay you more? Owning a Put can be treated like owning insurance on the stock from a loss in stock price.

Alternatively, if you think there is no way possible it will get down to $48 before the end of June, you may SELL a $48 AAPL June Put. HOWEVER, if the stock does dip down below $48, somebody will exercise their option and force you to buy their stock for $48. Imagine a scenario that AAPL drops to $30 on some drastically terrible news. While everybody else may buy the stock at $30, you are obligated to buy shares for $48. Not good! When you sold the option, somebody paid you a premium for buying that right from you. Often times you will always keep this premium. Sometimes though, you will have to buy a stock at a steep price compared to market.

Option Strategies

Example — I could buy a $52 AAPL June Call, and sell a $55 AAPL June Call. I would pay money for the $52 Call that I am long, and receive money for the $55 Call that I am short. The money I receive from the short $55 Call helps offset the cost of buying the $52 Call. If the stock were to go up, I would enjoy the profit within in $52-$55 range, essentially, maxing out my profit at $3/share – what the long/short call spread cost me.

There are dozens of strategies of mixing and matching long and short calls and puts depending on what you expect the stock to do, and what you want to profit or protect yourself from.

Conclusion

A derivative is any financial device that is derived from some other factor. Options are one of the most simple types of derivatives. The value of the option is derived from the real stock price.

Bingo? That’s a derivative. Lotto? That is also a derivative. Power companies buy weather derivatives to hedge their energy requirements. There are people selling derivatives based on the number of sunny days in Omaha.

Remember those calls and puts on stock prices? There are people that sell calls and puts based on the number of sunny days in Omaha. Sounds kind of ridiculous — but now imagine that you are a solar power company that gets “free” electricity from the sun and they sell that to their customers.

On cloudy days, the solar power company is still on the hook to provide energy to their customers, but they must buy it from a more expensive source. If they own the “Sunny Days in Omaha” derivative, they can make money for every cloudy day over the annual average, thus, hedging their obligation for providing more expensive electricity on cloudy days.

For that derivative to work, somebody in the derivative market puts a price on what he believes the odds are of too many cloudy days happening, and somebody who wants to protect his interests from an over abundance of cloudy days purchases this derivative. The energy company buying this derivative has a known cost for the cost of the derivative and works this into their business model.

Knowing that they will be compensated for any excessive cloudy days allows them to stabilize their pricing and reduce their risk. The person selling the derivative profits if the number of sunny days is higher than average. The people selling these types of derivatives study the weather in order to make their offers appropriately.

This particular example is a fictitious one (I don’t believe there is a derivative called “Sunny days in Omaha”), but the concept is real, and the derivatives are based on anything from sunny days, to BLS unemployment statistics, to the apartment vacancy rate of NYC, to the cost of a gallon of milk in Maine. For every situation, somebody is looking to protect themselves from something, and somebody else believes they can profit from it.

Now these examples are highly simplified, many derivatives are highly technical, comprised of multiple indicators as a part of its risk profile, and extremely difficult to explain.

These things might sound ridiculous, but if you ran a lemonade stand in Omaha, that sunny days derivative just might be your best friend…