What are the 6 positions/trades you can make with derivatives?
- Buy Futures
- Sell Futures
- Buy Calls
- Sell Calls
- Buy Puts
- Sell Puts
What does your payoff look like if you buy a future?
Buy a Future
What is the payoff if you sell a future?
Selling a future
What is the payoff if you buy a call option?
Buying a call
What is the payoff if you sell a call?
Selling a call
What is the payoff if you buy a put option?
Buying a put option
What is the payoff if you sell a put option?
Selling a put
What is the definition of a future?
A future is an agreement to buy something at a date in the future, at a price you agree now.
What is the definition of a call option?
What is the definition of a put option?
A call option is the right (but not the obligation) to buy a share in the future, at a price you agree now (the strike price).
A put option is the right (but not the obligation) to sell a share in the future, at a price you agree now (the strike price).
If you own shares (i.e. have a long investment in a share portfolio) and you want to hedge your risk, what two derivative trades can you do?
What are the advantages/disadvantages of the two methods?
- Sell futures (you don't have to pay upfront, but you don't make any money if the shares go up)
- Buy puts (you have to pay an upfront fee for the option, but keep any upside if the shares go up)
What does over-the-counter mean?
What is the alternative?
Over-the-counter derivatives is when you sign a private contract with somebody (typically a bank).
The alternative is an exchange listed derivative, where your contract is with the exchange, who will have another contract with somebody else in the other direction. To protect the exchange they make you post margin (basically giving them a deposit) and add more margin over time if the position moves against you.
What is the intrinsic value of an option?
What is the time value?
Intrinsic value is the hypothetical amount you would get if you exercised the option right now.
Time value is the difference between the price of the option and the intrinsic value (i.e. add them together the find out the cost of buying the option).
Intrinsic value is zero if the option is out of the money or at the money. It is positive if the option is in the money.
Time value is zero when the option matures (no time left!) and gets bigger the more time there is before maturity.
What are warrants?
Warrants are essentially call options.
What is an absolute return fund?
Do they focus more on alpha or beta?
Absolute return funds aim to make money regardless of what the market is doing.
So they aim for a very low beta (i.e. the market going up or down does affect their performance) but try to get a good alpha return.
What are they?
Basically a wrapper of derivatives offering the investor a specific return profile based on the performance of a stock or stock index.
They have a fixed term and can offer income or capital returns which are taxed in the usual way.
What is hard and soft protection?
Hard protection means that you have real capital protection, you will get your money back.
Soft protection means you get your money back, as long as certain conditions are met. Typically this means the stock index has stayed above a certain level for the whole life.
Two notable risks
Two specific risks for structured products to note are:
- Liquidity: There might be very limited secondary market to sell your investment before the maturity date.
- Credit Risk: You have credit risk with the issuer of the structured product, if they go bust you'll get nothing, regardless of the performance!