Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Financial Markets Unveiled Through Trading Strategies (S1 E6)
Embark on a financial journey with me, Edward Finley, as we decode the complex world of market trading, from executing spot, margin and short trades, to managing risks and speculating with derivatives. As we explore different types of trading, you'll grasp whether a trade is a bull or bear trade and the roles they play in the operation of an efficient market.
Discover the nuances of spot trading, the backbone of financial transactions where price represents collective market sentiment. Then, we crank up the intensity with margin trading; a double-edged sword that magnifies profits but can just as swiftly amplify losses. History repeats itself, and the stock market is no exception. We'll dissect the infamous crash of 1929, revealing how margin trading and overzealous investors set the stage for disaster.
Flip the script with short selling, where betting on a stock's decline becomes a way to make money and counteract market optimism. Yet, beware the short squeeze, a scenario where the tables can turn dramatically. Through real-world applications, the risks and mechanics of short selling come to life, painting a picture of a market that's as much about anticipation as it is about actual numbers.
As our expedition through financial landscapes continues, we delve into the pivotal role of derivatives. Futures and options are more than just complex terms—they're instrumental in price discovery and risk management. We'll dissect how you can use options to hedge against volatility or speculate for outsized gains, taking cues from historical events like the 1987 market crash. By the end of our dialogue, you'll understand how these sophisticated tools have transformed investor participation and honed the process of setting prices in our modern markets. Prepare to have your perspective on investments broadened, as we lay the foundation for a deeper dive into finance theory and probability theory in upcoming episodes.
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Hi, I'm Edward Finley, a Sumtime Professor at the University of Virginia and a Veteran Wall Street Investor, and you're listening to Not Another Investment Podcast. Here we explore topics and markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley.
Speaker 1:Well, so far, in episodes one through three, we talked about the three core securities markets in the US the money market, the bond market and the equity market. In episode four, we spent some time asking ourselves why markets? And in episode five, we thought a little bit more carefully about the roles of different participants in markets. In this episode, we're going to talk now about the next logical question, which is well, how is it that participants in these markets trade securities? And so we'll talk today about spot trading in its different forms, and we'll also talk about derivatives trading, and we'll talk a little bit about some examples of each of those. And again, innovations that can be very additive to markets can make markets more efficient, but oftentimes contain within themselves some issues that will come to bear on market more broadly and need to be corrected. So let's start with spot trading. We'll start with spot trading because, candidly, that's what most of us think of when we talk about a market and we talk about trading in markets, we're talking about spot trading. Basically, buyers and sellers come to a market, a spot market, and they express their views about the value of that security in price. Spot market prices are generally publicly available and the trades settle in predictable, predetermined ways. Most securities that trade in markets like stocks, options, commodities, derivatives are all traded on organized public markets, like we discussed in an earlier episode the New York Stock Exchange and the NASDAQ, for example, for equity securities, the Chicago Board of Trade for Commodities and ETFs, and the New York Mercantile Exchange for options and other derivative contracts. Bonds, however, are traded generally by a network of traders and not with any specific public market in which they trade.
Speaker 1:So let's start, then, with spot trading's most basic formulation, and that is called the long trade. The long trade is really neutral in terms of one's view, that is to say, the trade itself doesn't express a view. Which side of the trade you're on will tell you something about your view on that security. So long trades are just buying and selling a security. It's that simple. Those long traders who expect the price of a security to go up, we call bulls and they buy the security. Long traders who expect the price of a security to fall, we call bears, and usually they're only able to express that view in long trades if they currently own the security. That is to say, if you don't own it and you think the price is too high, with long trades only, there's very little for you to do. But if you do own it and you think the price has gone up quite enough and it's not going to go up anymore, that is your view is now that the security is priced too high, you'll express that view by selling it.
Speaker 1:Long trades risk the value of their investment and they earn returns when the price of the security is greater than the price that they paid for it. It's kind of an asymmetric trade then, if you think about it, because the maximum amount you can lose is the price you paid for the security but the most that you can gain is infinite. That is theoretically. I suppose the price of a security could go up and up and never stop going up. The risks when you're trading in the long trades on the spot market are very asymmetric. You can lose everything you invested but theoretically you can earn an infinite amount as a result of that asymmetry. Long trading, by its nature, often leads to bubbles because there's really very few ways to check the optimism among traders in the market. The only traders in the market if you're thinking about a market that consists only of long traders the only ones in the market who are bears can express those views if they own the security. But presumably, if they've decided that they don't like the security, they no longer own it. Long trades are something which is very typical, very common, but we see already a weakness in a market that has only long trades.
Speaker 1:It will come to some of the innovations that followed. A couple of other things to say about long trades. They require investors to provide the full price of the security. That seems pretty intuitive. If I want to do a long trade in buying Apple stock, I've got to have all the money necessary to buy Apple stock. But the consequence of that, of course, is that it limits the number of people who can come into that market and express a view. So, in order to bring more capital to markets, in order to bring more traders and more views because, as we'll discuss in a future episode, markets rely critically on lots of traders expressing views about an uncertain future Other forms of spot trading have evolved over the years so that bulls and bears can express their views on the prices of securities.
Speaker 1:So let's take up the first such innovation, and that's margin trading. Again, this takes place on the spot market, but margin trading is different than long trading in a couple of important ways. First, margin trading is always a bull trade. You are an investor who thinks the stock is going to go up in value if you're interested in investing in margin, it is not a bear trade. The way that margin trading works in operation is fairly simple. The investor borrows cash from a broker in order to purchase the security. The broker charges interest on that loan and, because the investor purchases the asset with some debt, it's a quote leveraged investment, and like all leveraged investments, changes in price are higher as a percentage of the invested capital than without leverage.
Speaker 1:So let me just give you a quick example of what I mean by that. Let's just say you wanted to buy shares of stock that traded for $100 a share, but you had only $10 to invest. Well, you could borrow $90 and then add it to your $10 and buy the security. Terrific, so you own the $100 security. Let's say there's a 10% change in price and let's make that to the good. So we're talking about margin trades. So you're a bull trader, so you hope it's going to go up, and let's say that it does. It goes from $100 to $110.
Speaker 1:And so you decide to take your profits. You sell the security for $110. That's great. What's the first thing you've got to do? You've got to pay back the broker. So what do you owe the broker? You owe the broker $90 plus a little bit of interest. But for our numeric example, let's keep it simple. So you pay the broker out of your $110 in proceeds. You pay the broker $90 and you keep $20. Well, how much was your original investment? $10. How much did you keep? $20.
Speaker 1:My rate of return was $100%. The change in the price of the stock was only $10%, but my rate of return was $100%. Let's look at it in the opposite direction. Let's say it's a margin trade I'm a bull, but I'm wrong and the price of the stock goes down. It doesn't go down by much, it just goes down by 10%. Again, I have 10. I borrow $90. I buy the security for $100. The security goes from $100 to $90. And I think I'm going to take my losses and call it a day. So I sell the security. My proceeds are $90. First thing I've got to do is pay back the broker. I give the broker all of the $90, and I have nothing left for myself. My rate of return was negative 100%. I lost all of it. The rate of return on the security was only minus 10%, but because I used a leveraged trade, I lost 100% of the investment. So margin trades and leverage trades in general will talk about lots of different kinds of leverage trades in the future, but leverage trades the best and most important thing to remember is leverage amplifies the upside and the downside.
Speaker 1:Well, happily, the Fed limits the amount of margin that an investor can use when buying securities and a person could not execute a trade like I just described. The Fed limits the initial margin on any security purchase to 50%. That means you have to have half the price in cash. You can borrow the other half. And then the Fed also requires that brokers keep what is called maintenance margin. Maintenance margin just means that the investor's equity in the investment that is, if they sold it and paid back the broker, how much was left for them. The equity in the investment must always be at least 25% of the position at all times. So, if you think about it, if you're required to come up with half in the first place and you must always maintain 25% in maintenance margin, then really what the Fed is saying is you can't ever lose more than half your money in a margin trade.
Speaker 1:Well, the value to the market is pretty clear. You can bring investors to the market who wouldn't otherwise be in the market because they didn't have sufficient capital to make those trades. You can enhance price discovery by having lots more traders in the market. You can give an enhanced voice to bull traders something more interesting to express their optimism more robustly than just a simple long trade. And it can also be used by sophisticated investors to fine-tune the kinds of risks that they want to own.
Speaker 1:Well, like all innovations in financial markets, this one, while it made perfectly good sense, resulted in a pretty big problem, and the example I'll give you is the 1929 stock market crash. Of course, the 1929 stock market crash did not have just one cause. There are lots and lots of causes, and academics have spent careers writing papers about it, but we're going to talk about the degree to which margin trading fueled an already dangerous bubble in equity markets inspired a panic, and that that in turn created at least the if it didn't create the crash, it made the crash a lot worse than it would otherwise have been. So let me set the stage historically. It's the 1920s. The US economy is going strong, they're low on employment, gdp is growing at a very favorable clip, there's booming industry all across the US and there's a nascent middle class, and this nascent middle class is increasingly these are households, remember. So they're increasingly earning more money, more than they need to consume. They save, and what do they do? Well, they make choices about that savings by committing that capital to investment and allocating it in markets.
Speaker 1:The stock market by 1929 had increased on average 20% a year for seven years. That's a pretty extraordinary record, and a lot of small investors coming from that nascent middle class added fuel to the market's rise during the 1920s because it was very easy to trade on margin. The rules that the Fed has in place today didn't exist. You could do a trade like I described a moment ago. You could come with 10% and borrow 90% or more. Overconfident agriculture and overconfident industries led to gluts in some very key sectors, and those gluts and key sectors led to a generalized economic recession and that recession, resulting from the fall and the prices of those items and fall in profits, led to a fall in the price of those shares. But by September of 1929, shares began trading down more broadly than just in those specific sectors and small investors who had made investments on margin began to sell because they didn't want to experience those 100% losses that were a possibility as I described. But of course, the rush of small investors to sell further pushed prices down further, causing other margin investors to rush to sell, and it created a situation like trying to catch a falling knife and the result is the stock market crash and the Fed margin limits are a direct consequence of that.
Speaker 1:Ways in which we can take this otherwise salutary innovation and make sure that it doesn't create any unintended consequences. The second new way to trade in markets that was developed by say new it's kind of funny to say new. It was developed in the 17th century really, but it was innovative compared to just long trades are short sales. Short sales are always bear trades, that is to say, an investor who engages in a short sale is a bear. They expect the price of the stock to go down and this is a way for them to make money by the fall in the price of the stock. Now, you'll recall, in long trading, if I'm a bear, the most I can do is sell the stock if I already own it, and if I don't own it, I just don't buy it. And that definitely exerts some downward pressure on price, no doubt about it, but it doesn't exert a lot of downward pressure on price. So short sales were a way for markets to try to counteract that tendency towards optimism in the long market by giving bear traders a bigger voice.
Speaker 1:So how does it work in operation? Well, in operation, the investor borrows the security from a broker and immediately sells the security on the open market. The investor then is required to take those proceeds and deposit them with the broker to be held in a low risk liquid security, typically T-bills or cash. The investor who has shorted the stock which is the phrase we use, or short sold the stock. The investor who has short sold the stock has to pay the broker interest on the borrowed security. Remember that security belonged to someone in their account, they weren't doing anything with it, and the broker is permitted to loan that security to a short seller if necessary. So the investor has to pay interest on the borrowed security. Plus, the investor has to pay the broker any interest if it's a bond that they've borrowed to short, and any dividend if it's a stock that they've borrowed to short. That is paid during the term of the short. And if you think about it, that makes a lot of sense. The security is owned by someone already.
Speaker 1:Let's say I own shares of Apple in my account and let's say you don't think Apple is going to go up, you think it's going to go down, so you'd like to borrow it and short sell it. Well, that's great. So you borrow my Apple shares, not from me. My broker is the intermediary who does that. As far as I'm concerned, I still own the Apple shares. I see them on my statement. There they are. You sell that on the open market, which means now there's a new owner of those Apple shares. There's technically two owners of the same share me and the one to whom you sold it.
Speaker 1:Well, if during the interim of the short trade, the Apple stock pays a dividend, when I look at my monthly statement I'm going to expect to see that dividend deposited in my brokerage account. But it won't be because the share isn't there. The share is in the brokerage account of the person who bought it from you. They are going to receive that dividend and by rights they should. They bought a share of Apple from you. They are entitled to the dividend. And so the problem that presents itself immediately in a short sale is well, how do I get my dividend? And the answer is the short seller is responsible to make me hold for the dividend. So, just to recap you borrow the stock through the help of a broker. You sell it immediately on the open market. Those proceeds are deposited with the broker, held either in cash or in T-bills. You got to pay the broker some interest for borrowing the stock. How much the interest is, by the way, will vary with how volatile the stock is. The more volatile the stock, the higher the interest is that you'll pay on it. And you also have to make the original owner whole on any interest or dividends paid by the security.
Speaker 1:The short trade can last as long as the broker can find shares to replace the ones that she lent to the shorter. Now, what do I mean by that? Well, let's use my example again. Let's say that I wake up one day and I say I don't think I want to own this Apple stock anymore. I'd like to sell it. So I call my broker and I say sell my Apple shares. Well, the broker has a problem, doesn't she? I don't have them. She lent them to you, you sold them on into the open market and so the broker has to essentially borrow those shares from another client's account so that she can sell them for me and give me the cash proceeds. So she's just replacing which share owner she's using to loan them out to you. Well, that means that as long as the broker can find shares to replace the ones that she lent out, the short sale can remain open. But if the broker is having trouble finding the shares to replace the lost, the lent share, then the broker is going to call the short seller and tell them they must close the trade. They must close the trade, that is, they must go and buy the shares on the open market, return them to the broker and close out the trade.
Speaker 1:And some of you, if you are at least passingly familiar with some of the headlines of the recent past, might be hearing in this description that I'm giving a risk of something that sometimes really does happen and that's called a short squeeze. Imagine the scenario where, if you have a stock that is increasingly going up, it is very popular stock, people sort of like it but there are some in the market who think it's not worth that and they sell it short. Well, that's fine, they can keep the trade open and the broker can find the shares until when? Well, if the ebullience, if the optimism in the market for those shares gets bigger and bigger, the broker is not going to be able to find those shares. And if the broker doesn't find those shares, then they're going to have to start forcing people to close out the trade. And so the short squeeze describes a situation where the price of an asset rises because of increased demand for that security. Short sellers then have to unwind their trade. But what happens when a seller short seller unwinds her trade? She buys the stock, putting further upward pressure on the price, causing other short sellers to have to close the trade, which means they buy the stock, putting further upward pressure on the price, and so on and so on. And this is a so-called short squeeze.
Speaker 1:The investor in a short is a leveraged investor. Here. It doesn't make any difference that what you did was borrow stock as opposed to borrow money. It's still borrowing and that means that the returns as a leveraged trade means that the changes in price are going to be a higher percentage for your total return than they would be without the leverage, because the shorter has no investment at stake. Right, if you think about that transaction, how much did you have to put up to short the security? And the answer is nothing. The result is that, in theory, a short seller's losses are theoretically infinite. It's not an asymmetric trade.
Speaker 1:Let's just do a quick numeric example just to make sure that this concept is locking up for you. We're going to use the example I walked us through just now. I'm an owner of Apple shares. Let's say it trades at $100 a share. You don't think it's worth $100. You think the price is going to go down. You borrow my shares, you sell them on the open market for $100, and you deposit that $100 with the broker and it's held in cash or in T-bills. Well, let's say you're right. Let's say that the share price of Apple drops from $100 to $90. And so you say, terrific, I'm going to take my profit. Well, how do you do that? Well, you close out the short by buying the shares that you borrowed from the open market. You buy them for $90. You give the shares back to the broker. Now let's pause and remember that means you're only out of pocket so far $90 because you just bought those shares to return them. The broker now gives you the collateral back worth $100, the collateral that you left with them when you first borrowed the stock and sold it. So now the collateral comes back to you at $100. You replace the $90 you just used to buy the stock and your profit is $10.
Speaker 1:But how much did you invest? Zero, you didn't really invest anything. You borrowed the stock, you sold it, you held the proceeds in custody with the broker. You briefly bought the shares in order to give them back, but you repaid yourself immediately. So you have nothing invested. You just made $10. Out of nothing.
Speaker 1:And let's look at the opposite transaction. The opposite transaction can be similar to the short squeeze I described. So we go and do a short sale when Apple is trading at $100, and unfortunately, you're wrong and Apple goes up to $110. And let's say you decide you're just going to cut your losses, it's just bad enough, you're going to close out the trade. You got to go buy the Apple stock. So you got to take $110 out of your pocket to buy the Apple stock and you give the Apple stock back to the broker. The broker then releases the original collateral to you worth $100. So you were out of pocket $110 to buy the shares back. The broker gave you $100. You lost $10. You lost $10 on what investment? Nothing. You didn't invest anything. You did it purely by borrowing the shares and so in theory it doesn't make a lot of sense. But if you think about it in theory, that $10 loss is an infinite loss, because if you didn't invest anything and all you had was a loss, then you have an infinite loss.
Speaker 1:Short selling is useful to markets in the ways I described just a moment ago. It brings more traders to markets, adds to the ability of lots of point of views. Importantly, it gives a much greater voice to those who are bears on a security and helps counteract the market's natural optimism. One can use shorts in a way to hedge a position that they already have we haven't talked about hedging, but we will in a moment and it puts some increased liquidity in the market because, technically speaking, the same share of stock can be sold multiple times.
Speaker 1:The case study I'll offer you here is not really a case study of something going wrong with short selling, but instead is just an example of how short selling is almost always going to be stocks and not bonds. And the reason is because bonds by their nature present a very, very difficult problem. So, unlike a stock, there are really potentially two reasons why prices will change for a bond. One is that there's a change in prevailing interest rates, and the other is changes in the fortunes of the issuer. That is, the issuer becomes either stronger or weaker and the bond becomes either less risky or riskier. So there's two different things going on, which makes it rather more complicated to predict whether, I think, the price is going to go up or go down, unlike a stock. Also, the coupon on a bond will typically be much, much higher than the typical dividend on a share of stock, and that puts a lot of cash flow pressure on the short seller and it results generally in only the most sophisticated traders short selling bonds.
Speaker 1:Let's turn our attention now to the second way in which securities trade, the first being the spot market, where we have long trades, we have margin trading and we have short selling. The second typical way in which securities trade in markets is derivatives trading. Now, before you get too uptight about the word, because it's sort of for a lot of people it sounds like it's a very complicated concept, it really isn't complicated at all. First let's just define what a derivative is. A derivative is a security that has no intrinsic value but whose value is based entirely on the value of some other underlying security. So let's just repeat it Derivatives are securities that have no intrinsic value but whose value is derived. Ergo the word derivative whose value is derived or based on the value of another underlying security.
Speaker 1:The first of the derivatives that I'd like to cover are futures and forwards. I'll describe them first in operation and then we'll talk a little bit about what they're for. So, futures and forwards both are contracts for the delivery of an asset in the future. As the names suggest, futures are securities. They are derivative securities. They are contracts with standardized terms and therefore futures trade as securities. Fullwords are not securities. Fullwords are contracts that have customized terms and therefore they usually don't trade. They're used on a one-off basis by very sophisticated people who have need for that exposure one way or the other. So, futures and forwards the same idea a contract for future delivery of an asset. Futures, with their standardized terms, are securities and they themselves trade in markets.
Speaker 1:The typical terms of a futures contract will be the quantity of the security, its price, the specified maturity or delivery date and the method of delivery. The long position so-called long position of a futures contract is the person who's committing to purchase that asset in the future. So if I am signing a contract saying, yes, I will buy one share of Apple from you in three months, I have the long position on a futures contract for Apple shares. The short position is the person who commits to deliver that asset in the future. And so if you agree to deliver me a share of Apple in three months for a set price, then you have the short position on that futures contract. What's important to understand about futures is that the longholder and the shortholder the long side and the short side of these contracts are obliged to execute the contract. They are obliged to sell the asset, purchase the asset, depending on which side you're on. So the longholder is obliged to buy, the short side is obliged to sell, and this is different than options, which we'll talk about in just a minute, another kind of derivative.
Speaker 1:Futures prices are determined by several things. We're going to go into this in a lot more detail in future episode, when we talk about commodities and other real assets, but for now, all we need to understand is that the futures price is going to be determined by a mix of the current spot price of the security, the risk-free rate, which typically, as we've talked about, is the rate on treasury bills. The cost of storing the asset, if there is one. So if you've got a futures contract on oil, there is some implicit cost to storing the barrel of oil for three months until the contract matures, but in other securities, like Apple shares, there are really no costs of storage. And then, lastly, something called the convenience yield. The important thing to understand about the convenience yield is that it's not observable. It's not something that we can see measure in the marketplace. Instead, we can only imply it from what the futures prices are, and so the convenience yield is understood generally to be the implied expected return on holding those assets as inventory. So the spot price today, the risk-free rate, the neat costs of storage and the implied return on holding that asset as inventory.
Speaker 1:Why have futures contracts? What role in markets does allowing traders to engage in transactions like this in the future. What role does it play? Well, it plays a couple of roles. First, it really aids in price discovery in the market, that is, as traders attempt to incorporate information into the prices of assets. We can bring more of those traders into the market with futures because they don't actually have to buy the asset in order to express the view. They don't have to buy shares of Apple. They don't have to borrow them and sell them if they're bears and short traders. They don't have to borrow money to buy it if they're margin traders. Instead, they can simply enter into this futures contract. They have to post some collateral for the futures contract, but it's usually rather modest. They post some collateral for the futures contract and therefore you're expressing either a bull view if you're the future long side, or a bear view if you're the future short side.
Speaker 1:It's also a very, very useful tool to hedge, and I told you earlier I'd explained that a little bit. Here's a good moment to explain it. Say, I know that I need an asset in the future and I don't want the risk of an increase in price. I know. Say I have an airline and I know I need oil and I buy it every three months. Well, if I'm worried about a short-term jump in the price of oil, I might avoid that risk by buying a three-month futures contract on oil. And lastly, it can really be a tool for speculation Investors, who simply take a view on the convenience yield. They take a view on the expected return of that asset held in inventory and they can leverage their trade using futures, because, of course, futures are also leveraged trades. You have only a small amount of collateral held with the broker to execute a futures contract, otherwise you don't have anything at stake.
Speaker 1:Okay, let's turn finally to options. Options are the last of the derivatives that we'll discuss and can be just as important as futures or, in some senses, more important. The first thing I will tell you is that options the main difference between options and futures is, as the name suggests, options are not an obligation to buy or sell by the holder of the option. The holder of the option has the option to buy or sell. That's the big difference. If I'm the holder of a futures contract, I am obliged to buy the security at the maturity or the end date. If I buy an option and I'm not obliged to buy or sell it, depending on the kind of option. I just can choose whether to do it. All right.
Speaker 1:So how does it work in operation? Well, an option is a contract like futures, giving the holder the right to buy that's a call option or the right to sell that's a put option. Any asset, the purchaser of an option of either kind purchaser of a call, the right to buy, purchaser of a put, the right to sell pays a premium for that right, and the call option premiums and the put option premiums will vary depending on what the strike price is relative to the current spot price, strike price where'd that word come from? The strike price is the price in the option contract at which you agree to buy or sell the security. When I'm paying a premium, that is to say when I'm buying an option, I'm going to be a bull or a bear depending on which kind of option I'm buying. So if I'm buying a put option, then I'm a bear, because a put option gives me the right to sell at the strike price and I will have chosen a strike price below the market at which I will choose to sell and I'm going to make money on that because I expect the price to go down. If I'm buying a call option, that's a right to buy the price at the strike price and that means I'm a bull because I'm going to choose an option that has a strike price that's higher than the current market price so that I can exercise it and make money.
Speaker 1:Buying options is leveraged because the only risk of loss is the premium you pay. In the case of a put option, there's a possibility of profit equal to the full price. You can't earn more than the full price in a put option if I'm long a put and a theoretically infinite profit with a call option, because the price could theoretically go to infinity. Let's give a quick numeric example just to see how this works. We'll start with buying a put.
Speaker 1:Let's say I'm a bear. I think that Apple, currently trading at 100, is going to go down. I could, on the spot market, go ahead and short sell Apple. That's one of my options. But another option is I can buy a put on Apple and when I buy a put on Apple, that is a contract in which I say I want to acquire the right to sell Apple at 100, let's say at today's market price. Okay, so someone out there is willing to sell me a put. That means they're a bull. They think it's going to be higher than a hundred, so they're very, very happy to be on the other side of that trade. I think it's going to go down and I pay a premium for that and, based on the volatility of Apple, the premium could be anywhere from one to 4% of the of the transaction cost.
Speaker 1:All right, let's say I'm right. Let's say that Apple goes from a hundred to 90. And I have this contractual right to sell Apple to the counterparty at a hundred. Well, what am I going to do? I'm going to exercise my option for sure, because the market price for Apple has gone to 90. So I go out into the open market and I buy a share of Apple for 90. And I present that Apple share to the counterparty of my option and I say I'm exercising my option. You promised to buy this for me for a hundred. Here it is. So they give me the hundred.
Speaker 1:I was out of pocket 90 and I made 10. The only thing that I put in risk is my collateral. I get the return of my collateral and I make money. The same if I buy a call. If I buy a call, I'm going to be a bull. So let's use my Apple example Apple's at a hundred. I think Apple is going to go up from here and so I'm interested in buying a call. So I'm prepared to pay a premium to buy a call on Apple stock that will be at, let's say, one 10. Now if it goes up to one 10, I haven't made any money, but I also haven't lost any money. But if it goes up to one 20, then the same scenario in here is I exercise my right to buy the Apple stock at 110.
Speaker 1:And the person who sold me that option contract have to go out into the market. They got to buy it for 120 and present it to me, and then we execute the trade and I make the difference between one 10 and one 20. Now I give you the examples of actually the buying and the selling. In truth, with options, it isn't usually the case that those transactions happen. Usually options are what are called cash settled. Cash settled just means that when someone exercises the option, nobody has to go out and buy and sell. You just tally up the numbers on either side of the trades and then the person with the net positive or net negative result has to either collect or pay on the trade.
Speaker 1:One of the phrases that involves options that you'll hear potentially hear from time to time is that if an option is in the money, it means that the option has value and I could choose to exercise it and make a profit. So if it's a call, if I own a call and it's in the money, it means that the market price is currently above the option strike price. If I own a put I bought a put, so I'm a bear it would be in the money. If the market price is below the strike price, out of the money is just the reverse. If someone says that an option is out of the money, it just means that the option has no value and it wouldn't be exercised. And that's really the important point to make here about options is that let's say you're wrong. I gave examples in the call and the put where the owner is right. But let's say the owner is wrong. So you buy a call on Apple and you set a strike price at 100 and you think that Apple's going to go to 120. So you're ready to rock and roll, but in fact Apple goes to 90. You just don't exercise the option. It expires worth of money, it expires worthless. What did you lose, you lost the premium that you had to pay in order to have that transaction. So, in summary, buyers in call options expect the price of the asset to rise, buyers of put options expect the price of the asset to decline, and we can see that these are leverage trades, because the only amount at risk is the premium.
Speaker 1:Over the years, I've always had a student and I'm very confident that one of you listening here today is thinking this question to yourself right now which is then I don't understand why anybody would ever buy stock. Why not just always buy call options? I don't have to come up with all the money. I'm not limited by 50% margin. The Fed limits me to 50% margin. Here. The only thing I have to pay is the premium, and Finley just told me that that might be anywhere from. You know two, four, 6% of the transaction cost.
Speaker 1:Everybody should just buy call options, and the answer to why that's not true is remember, these are contracts, and so in order for someone to sell you that call option, they have to be prepared to take the opposite view. They have to be a bear. And so if there is very positive, optimistic views about a particular security and you'd like to buy a call option, you'll find that the premium is so high that it's simply not worth the transaction. Likewise, buying a put is the same. You just might find that the premium is so high if everybody is negative on the stock and you want to buy a put option, the premium is so high that you're very unlikely going to make a profit. Okay, what are the values of options, whether they're puts or calls to the market? It kind of parallels the same as I described for futures contracts. Here there's just one slight little difference, and I'll kind of go a little bit more deeply now into this notion of hedging.
Speaker 1:There are two kinds of ways we can think about using options, and they're typically referred to as covered and uncovered. So what are we talking about with covered? Covered means you're writing an option on an asset that you already own. So let's say I have an existing position in Apple and I am very happy owning that Apple. I don't want to sell it, but in the short term I'm very uncomfortable with the risk of short term price movements. Well, what I can do is I can go ahead and buy a put, that is, I can buy the right to sell Apple at a certain price and I can simultaneously sell a call. That is, I can promise to deliver Apple at a certain price and I can match up those maturities on those call and put options so that the premiums that I have to pay to buy the put roughly equal the premium I earn when I sell the call. So I don't have to spend any money. But it means I've put contracts around the current market price of Apple to give me that buffer, that hedged buffer.
Speaker 1:This is called covered hedging and that's the kind of covered hedging you do without a cost zero cost hedging. You can also hedge an existing position, not with zero cost, by using just one option. So you can say I own Apple, I'm really worried about a short term price drop, so I buy a put. If the price does fall, I can sell my position at the higher contract strike price than the market price and yes, I lost the premium in the mix. But I saved myself a lot of heartache. If that share of Apple goes from not 100 to 90, but goes from 100 to 50 and I've got that put option in my hand, it means I can sell that Apple stock for 90 and have only a $10 loss, not a $50 loss.
Speaker 1:The other kind of use of options can be speculation, that is, just investors who are in the market and expressing a view positive or negative on a security can engage in buying or selling options. So, for example, a bull who thinks a stock will go up can earn profit by buying a call. The investment is the premium, the profit is the change in the value of the share, and so the return on investment is going to be higher than owning the stock itself, because it's leveraged and it limits my loss to the premium, because if I'm wrong all I lose is the premium, whereas if I bought the stock it could go to zero and if I shorted the stock I might actually have to suffer those losses. Let's do just a quick case study of options and some of the consequences that can result. So we'll turn the clock now back to 1987, it's the autumn of 1987.
Speaker 1:There was a weak dollar, there was risk of inflation, there were relatively high interest rates and so the feds raising rates in order to support the dollar was not really an option. So it looked pretty bad for US companies competing in a global economy. The dollar is weak, there are risks of inflation, interest rates are already quite high. Fed can't raise interest rates to support the dollar without further stymieing the economy, and if they lower interest rates any longer, it'll further weaken the dollar. So equity prices had been in decline for several weeks. Investors in US equities were not very optimistic about equities in the short run.
Speaker 1:Index futures and something called portfolio insurance, which are the kinds of option strategies I described above, either no cost or with a premium, and either covered or uncovered. These were, verily heavily used by large institutional investors at the time, and computers were making the decisions about whether to sell covered positions or short other positions as market prices moved. The trouble was that the computers overreacted to the initial price changes and began to sell covered positions, which then put in place a market drop that was rapid and precipitous, all accentuated and really very, very highly charged by the existence of options. If traders were only engaged in long strategies here, the consequences wouldn't have been nearly as great. So in some how, securities trade in markets is a bit complicated, but it's not terribly complicated when you think of it simply from the perspective of the operation of markets.
Speaker 1:To fulfill the promise that we've described from the very first episodes, we have the spot market with long trading that leads to kind of unnecessarily robust optimism. No way to check optimism. So we add short selling. Short selling gives more robust voice to those who have negative views. We also add margin trading to kind of balance that out and give equally robust voice to positive views. We introduce the derivatives market to bring futures and options to the table, where they're yet further leveraged. They are themselves very different from the underlying securities, but it has the consequence of bringing more and more investors to the market in order to help try to explore what the value of securities are.
Speaker 1:So that's it for the securities trading segment. When we come next time, we're going to introduce a little bit of finance theory to say, all right, well, we're bringing all of these people to the market. Why, what is it that we think is useful about having so many more people coming into the market and trading? We'll talk a little bit about some finance theory. We'll talk a little bit in the following episode about some probability theory and then we'll make a big pivot and we'll start talking about investments as asset classes. So that's it for now. Thanks for listening. You've been listening to Not Another Investment Podcast hosted by me, edward Finley. You can find research links and charts at NotAnotherInvestmentPodcastcom. Don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
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