Do you find the stock and bond markets too tame for your tastes? Have an inkling which way soybeans, Treasury securities or Microsoft shares will move in six months, two weeks or two years?
If steady, patient value investing is too slow for your tastes, you may be hankering to invest in derivatives.
Derivatives are essentially bets on the movement of stocks or other financial instruments. While their value is based on, or derived from, the underlying asset — a stock, a bond or a promise to deliver a commodity like pork bellies or frozen orange juice — they have no intrinsic value at all, and their value can vanish in a flash.
If this sounds risky, it is.
Generally, derivatives are used by large investors and corporations to manage risk, reduce costs, take advantage of a loophole in accounting rules or government regulations or just to speculate and make money.
Derivatives are not only for the very big guys. Many investment funds, banks and brokerages now offer derivative products even for small investors. But the rule remains the same: the greater the potential rewards, the greater the risks. Entry prices can be as low as a few hundred dollars to buy a futures contract or some other derivative traded on exchanges including the Chicago Board of Trade or the New York Mercantile Exchange.
Options, one of the most common forms of derivative, are the right, but not the obligation, to buy or sell a specific stock, bond or contract at a specific price and within a specified time. They are definitely not for small investors. You should only play with them using money you can afford to lose.
That said, if you enter the world of options, there are a few things you should know:
Options allow you to lock in the price of a commodity or a financial instrument for a set period. They can be used to protect you from the decline in value of a position, guaranteeing you can unload a stock when it falls below a certain price. They can also be used to lock in a lower purchase price if a stock jumps in value without your having to buy the stock itself.
So by fronting only the small amount of money needed to buy the option, you can reap the full amount of the stock price jump.
The world of options is vast, and options can be used to bet on the movement of markets, indexes or even the weather — useful if you are in a business like ice cream or heating oil, whose fortunes vary with the climate. Corporations often use options to protect themselves from exchange-rate fluctuations.
There are effectively two types of options: calls, which allow you to lock in the price at which you can call, or buy, an asset; and puts, which allow you to sell at a set price, which is called the strike price.
Here's how they work. Let's say you think that with all the violence in Iraq, the price of oil will go up to $60 a barrel. But you do not have the cash on hand to buy 1,000 barrels of oil at $45 or $50 each and hold on for six months. Instead, you can purchase an option to buy the oil at a fixed price, based on the market's view of its likely price in the future, whenever you like in the next six months.
Of course, since there is no such thing as a free hunch, the fellow selling you this option wants you to pay for it. The good news is that he only wants you to pay a small fee up front for each option. At Charles Schwab's online trading site, for instance, options can be bought for as little as $1.40 per contract, after a $9.90 transaction fee.
If oil goes up enough that your option is "in the money," you will exercise your call option and receive the monetary difference between the market price of oil at that time and the price that you locked in when you bought the contract. If it rose from, say, $50 a barrel to $60, that would mean a profit of $10,000 — $60 minus $50 times the 1,000 barrels — minus the cost of the option and any other commissions.
The even better news is that the whole transaction is carried out electronically, so that you will never be asked to put up the $50,000 it would cost to buy the oil, nor sell it off immediately for $60. The whole thing is a financial transaction, or a contract for the difference.
But options also expire, and if peace suddenly comes to Iraq and the price of oil falls below the call option's strike price of $50 and stays there until the option expires in several weeks or months, you lose the money you paid for your option, and the whole transaction is a net loss.
Millions and millions of such transactions are what keep the markets lubricated. But because the players only have to put up a small portion of the value of the underlying security, options trades can also go badly wrong.
Remember that most people who deal in options and any of the dozens of other derivatives available need to have considerable knowledge of the markets and the forces influencing them, in addition to deep pockets and the ability to weather significant losses.
Still, if you insist on putting your money in such a risky spot, keep in mind that most financial experts say the key to solid returns is asset allocation. Don't bet the house on the price of heating oil, and don't think that a single swift bet on pork bellies will bring home the bacon.