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Keep your options open on derivatives
Leveraged investments offer huge profits, but can turn into a minefield for the private investor. DAVID BULLARD gives a simple guide to options
Derivatives, as their name suggest, are financial instruments that "derive" their price from other financial instruments such as bonds, equities and precious metals. The term embraces things like options, futures and warrants. The attraction (and the problem) is they are leveraged investments - meaning while returns may be spectacular for a relatively small outlay, the opposite may also be true. Barings' problems caused banks and regulators to re-examine the desirability of derivatives, but in the end there was only one conclusion. If Barings' senior management had educated themselves about these instruments they would still be in business. Derivatives traders love to surround themselves with all sorts of technobabble buzz words. This sets them apart from your average stockbroker, and lends the mundane business of options trading an esoteric impenetrability. The result is that people believe derivatives traders are extremely clever (which they're not) and the market is terribly difficult to understand (which it isn't). Having a few weeks ago suggested the private investor is not welcome in the bond market and should head for a reputable unit trust, I can now give you the good news. If you have around R100 000 to spend and a high threshold of pain, you can occasionally make a very handsome profit in bond options. The problem is most people who dabble in this market don't do their homework. The most important thing to understand is that you stand to lose your entire investment. If that doesn't appeal, turn to Prince Valiant. First things first. What is a bond option? It is the right but not the obligation to buy or sell an amount (normally R1-million nominal) of a certain bond (the R150 for example) at a pre-agreed price (known as the strike or exercise price) by a certain date (the exercise date). A "call option" gives you the right to buy the bond and a "put option" the right to sell.You are under no obligation to exercise the option. For this right you pay a price - the "option premium". SA's bond option market started 13 years ago and pre-empted the futures market. The result has been the growth of a very efficient and liquid market. However, it is what is known as an "over the counter" market. This means every time somebody buys or sells an option, a physical contract passes between the respective parties the next day. The option purchaser will hold on to that contract until he either sells it to someone else or exercises it (cashes it in). The option document is the only evidence of ownership and should be treated like a share certificate. So what are you actually paying for when you buy an option? While the complex calculation of an option premium is intended to produce a fair value price, all you are really paying for is time and probability. The longer the period of the option the more you would expect to pay for it - simply because you have more time for your market view to come right. Similarly, if you were to buy a call option on an ounce of gold giving you the right to buy at $340 any time within the next three months, you would spend more than you would on one that gave you the right to buy at $380. This is because the probability of gold reaching $340 is greater than that of it reaching $380. So the greater the time and the greater the probability, the more you will pay. Unfortunately, it's impossible to talk about options without resorting to some of the market jargon. There are a few terms you need to know. Options that still have some way to go before they show a profit are known as "out of the money options". Options with a strike price identical to the market price (for example, the gold price is $340 and you have a call or put option at a strike of $340) are known as "at the money options". Options which can be sold at a profit are "in the money options". There are two types of option: American and European. American options allow you to exercise (cash in) that option any time up to the exercise date and European options allow you to cash in only on the exercise date. SA follows the American style. One of the major problems with understanding the market is that bonds are quoted in terms of yield to maturity (YTM). This means that if the R150 is trading at 14.50%, its price will rise as the YTM falls. So, if you believe that interest rates are likely to fall over the next few months you might decide to buy a 14.00% call option with a February expiry for R9 000 which is today's approximate ruling price. At current levels that price of R9 000 represents 22 basis points on the R150 stock (currently a point or 0.01 is worth around R407), so the R150 will need to drop to 13.78% (14.00% strike rate less 0.22%) before you recover your premium and start to make profits. However, the bond option market is a traded market and you don't need to wait until February to see if you have made a profit. If rates fall early in the life of this option, its market value will rise substantially. For example, when interest rates rose sharply in early 1996, an investment of R100 000 in put options would have been worth R3 000 000 just six weeks later. Easy money - and all you needed was the ability to predict the future.
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