John W. Coughlan, PhD, CPA, CMA

You are about to delve deeply into the interesting - the fascinating - world of derivatives. They can be used to increase your return on your investments; but be careful as they can cause great losses. They can be used to reduce the riskiness, the volatility, of your portfolio and they can be used in just the opposite manner to give you a wild ride on a roller coaster of ups and downs.

If you complete this interactive course and pass the quiz at the end, you can print out a slip for four hours of "continuing professional education" (CPE) for your CPA or CMA or other professional designation. While state boards of accounting, the Institute of Management Accounting and other professional bodies set what they accept for CPE purposes, we are not aware of any one of the many people who have used this course for CPE purposes ever being challenged. We assure you that you will get more knowledge from this four-hour CPE Program than from any day you might spend in a classroom for eight hours CPE. More to the point, you are about to enter the fascinating world of derivatives.

Ernie's Problem

Ernie has a terrible problem. In 2000, when his life savings were $1 million, Ernie invested all $1 million in a hot technology stock. Yes, Ernie still has the stock and it still constitutes 100 percent of his net worth and, yes, Ernie is happy that his net worth is now $500 million. But for some reason Ernie can't sleep.

His wife, still complaining about his television obsession, notes that his fascination with Manning and Ovechkin has given way to an absorption with Page and Zuckerberg. His psychiatrist, observing that his Freudian slips involve "silicon" and "valley," thinks he has a mammary fixation.

His broker, while endorsing diversification, is not sure Ernie's plan to put 10 percent of his portfolio in Google, 10 percent in Intel, 10 percent in Facebook... will cure his insomnia.

Ernie now explores the use of a "put" to protect himself from downside risk. (Upside risk does not bother him.) In return for a small consideration (the "price" or "premium"), Ernie can buy a put that gives the right (but not the obligation) to sell his stock at a stated price anytime in the next several months. Suppose his internet stock currently sells at $100/share and that for $3 premium he can buy a put that gives him the right to deliver his stock for a "strike" or "exercise price" of $90 anytime in the next eight months. If the stock should "tank" to $40 a share (he remembers it was there a year ago on the way up), then Ernie can deliver his stock and get $90 per share; he ends up getting $90 per share less the $3 price of the put, or $87. Now $87 is less than the $100 at which it is now trading but it's a lot more than the $40 to which he thinks it might return. If his internet stock instead continues to rise in value then he won't exercise the put and will let it expire worthless at the end of the eight months. In that case, Ernie will consider the $3 premium per share as the cost of "insurance" against a precipitous plunge in price.

A put is an example of a derivative. While a few types of derivatives have been around for centuries, many have been invented and have become prominent in the last seventy years. Just as you now need to be familiar with computers and the internet, in the 21st Century you're not able to operate in the fields of accounting or finance without a basic knowledge of derivatives. You need to know the tax treatment of puts, you need to know how to reflect futures contracts in the balance sheet, you need to know what "marked to market" means, you need to be derivative literate just as you need to be computer literate.

Types of Derivatives

A list of all the existing derivatives would be very long and would be incomplete almost immediately as new ones are being invented or created all the time. You will find in the following pages, however, an introduction to the following common types of derivatives:

Options on Stock

Options are instruments that may or may not be exercised at the volition of the buyer of the option. By contrast, the seller of the option (also callled the "writer") has limited freedom of action. If the buyer of the option decides to exercise the option then the seller must live up to her side of the bargain.

Consider a simple example. Sam thinks the price of General Motors (GM) stock will rise above its current $70 per share. He accordingly buys a call option from Mary on 100 shares of GM stock with a strike price of, say, $75 per share. Let's say this option is for 8 months. Sam will have to pay Mary something for this option. Let's say he pays Mary $4 per share or $400 for this option. Let's say that at the end of 8 months Sam still has the option and GM stock is selling on the market at $69 per share. Sam's option will expire worthless at that time. If he wants 100 shares of GM stock he will buy it through his broker for $69 a share. There wouldn't be any point in exercising the option and thereby paying $75 per share to acquire the GM stock when GM can be bought on the open market at $69 per share. Sam will regret having bought the option as he is out the $400. Mary of course will chuckle as she has Sam's $400 and does not intend to return it; she is ahead $400 because she sold the option. (Quite possibly Mary owns 100 shares of stock in which case she has sold what is known as - see below - a "covered call." If so, she regrets, of course, that her GM stock has gone down from $70 to $69 but the $100 pain from the decrease in the value of her stock is more than offset by the $400 pleasure she got from Sam's premium.)

Same scenario except that at the end of eight months GM stock is selling for $90 a share. Sam is pleased and he exercises his option; more specifically he writes a check for $7500 and gives it to his broker along with instructions to exercise his option. The cost to Sam for the 100 shares of GM is therefore the $7500 he pays at the end of the eight months plus the further $400 he paid for the option at the beginning of the eight months. In total the 100 shares have cost him $7900 but notice that they are worth $9000 (or 100 shares at $90 per share). Mary is not so pleased with the transaction. Yes, she received the $400 eight months ago and may have earned $6 interest on the money in her money market account and yes she appreciated the further $7500 she has just received from Sam. She has received perhaps $7906 in total on this transaction. If, however, she has to go out on the market to buy the stock so she can deliver on her end of the bargain, Mary will have to pay $9000 and this is not at all to her liking.

CHECK YOUR COMPREHENSION

If the GM stock is selling at $85 at the end of the 8 months and Sam and Mary have retained their original positions over the eight months, which of the following is true:

Sam and Mary both laugh.
Sam and Mary both cry.
Mary laughs; Sam cries.
Sam laughs; Mary cries.

You will find it useful to get some of the basic terminology and some of the basic concepts fixed in your mind before you proceed to the real fun of options trading. The 'real fun' of course comes with how you use options to increase your return and/or reduce your risk. We'll get to these subjects presently but for the next several paragraphs, we're going to give you a somewhat more exact idea of what call options are about. After that we'll talk about some of the mechanics of options and more particularly about the relationships between the parties. Then let's proceed to the fun part.

A call option gives someone the right, but not the obligation, to buy a particular asset - a particular stock in this discussion - at a specified price during a particular period of time. If you buy the option, you can decide at any time during that period whether you want to exercise the option. In the above example, Sam was the person who bought the option and he has the right to exercise the option within the eight (8) months that the option remains open.

The person who sold or 'wrote' the option - Mary in the above example - has the obligation to deliver the stock if the person who bought the option decides to exercise. If Sam sends Mary a check for $7500 within the period the option remains alive, she must deliver to him the 100 shares of GM.

The 'exercise' price (also called 'strike' price) is the price per share that Sam must pay if he exercises his option. It is the $75 per share in the above example.

Distinguish between the exercise price and the premium. The exercise price - $75 in the example - is what Sam must pay if he decides he wants the stock and it will normally be paid at some date after he buys the option, perhaps several months later. The 'premium' or price of the option is what Sam must pay Mary at the beginning to compensate her for accepting the obligation to deliver the stock if he decides to exercise. The 'premium' in the above example is the $4 per share that Sam pays, or $400 for the 100 shares, when Sam enters into the option with Mary at the beginning. Note that the premium is usually quoted as so much per share ($4 in the example) although the typical option contract is for 100 shares so Sam will pay $400.

The 'underlying' asset in this case is the 100 shares of GM stock that Sam can get and that Mary must surrender if Sam decides to exercise. Various other 'underlying' assets. could be the subject matter of an option contract. In our discussion here, however, the 'underyling' asset will be shares of stock although there will also be some mention of index calls which relate to an index such as the Standard and Poors 500 or the Nikei. In discussions of options and other derivatives, the underlying asset - or more particularly its price - is sometimes referred to simply as the 'underlying.'

There are 'American' calls and 'European' calls. An American call can be exercised at any date before maturity. Sam could write his check for $7500 and ask for his stock at any time during the eight months. By contrast, a European call can only be exercised at maturity. If Sam's option were European he could only exercise just before the end of the eight months.

Calls may be 'covered' or 'naked.' For the option market to work, there must be some assurance that the person who 'writes' or 'sells' the option (Mary in our case) can live up to his/her obligation if the person who bought the call (Sam) should exercise. One way to get this assurance is to have Mary 'put up' or 'deposit' 100 shares of GM when she sells the option; that way we would know that Mary could deliver the 100 shares when called upon to do so as she has given the 100 shares to her broker. Such a call would be referred to as a 'covered' call. If Mary does not own GM stock, then she will typically be required to deposit with her broker "margin" (money or other securities). Such a call where the writer of the call does not own the stock is often referred to as a 'naked' call.

CHECK YOUR COMPREHENSION

Mary has written a 'naked' call. Click on the appropriate answer:

Mary should be ashamed;.
Her Mother should be ashamed;.
Mary works in the oral office;
Mary does not own GM stock and may have to post margin with her broker.

You should understand that options - including the call options discussed in the last few paragraphs - are very speculative, very risky financial instruments. By risk reference is made to the spread, scatter or "standard deviation" of the return from the financial instrument. One financial instrument is riskier than another if the spread, scatter or standard deviation of the return on that instrument is greater than the similar spread, scatter or standard deviation on the other.

The risk relating to a call and to other options is generally greater than the risk relating to the "underlying" financial instrument. Thus the risk relating to a call is generally far greater than the risk relating to the related stock.

To illustrate, suppose that MicroSoft (henceforth MSFT) stock is selling on the market at $100 per share and Sam thinks it will go up in price over the next several months. He is considering whether to buy 100 shares of MSFT or whether to buy a call on 100 shares of MSFT. Suppose there is an equal probability that MSFT will decline to 50 or rise to 150 over the next several months and suppose further that the price of a seven-month call on MSFT at a strike price of $100 is $15 per share. Which instrument - the 100 shares of MSFT or the call on 100 shares of MSFT has the greater risk?

If Sam invests in the 100 shares of MSFT it will cost him $10,000 (or 100 shares X $100). If the stock goes down in price to $50 at the end of nine months, Sam's stock will be worth $5,000 (or 100X$50) and Sam will have suffered a loss of 50 percent (or a negative return of 0.5). Just divide the $5,000 decline in value by the initial investment of $10,000. If the stock goes up in value to $150 per share he will have gained 50 percent or a positive return of 0.5. More specifically, his stock will be worth $15,000 and the $5,000 increase in value represents a 50 percent gain over the initial investment of $10,000. Suppose that MSFT will either go down to $50 or up to $150 and that the probability of each event is 0.5. Then Sam's expected return is determined as follows:

  • Loss -0.5X50% = -25%
  • Gain +0.5X50% = +25%
  • Total return = -25%+25%= 0%

Sam's expected return is nothing! But note that the risk is considerable: He could lose either 50 percent of the value of his investment or gain 50 percent. We would say this is a risky investment.

But if you want to consider risk, now look at his purchase of the call which would cost him $1500. If the stock goes down in value to $50 per share, his call will expire worthless at the end of the seven months. He will have lost 100 percent of his investment or his return will be minus 100 percent! If, by contrast, MSFT goes up in value to $150 at the end of the nine months, his option will have an "intrinsic value" of $5,000. More specifically, he could exercise the option by paying a further $10,000 and thereby obtain stock worth $15,000. Assuming he could exercise (pay $10,000) and sell the MSFT thereby obtained on the same day, he would be ahead $5,000 on that day. That's a return of $5,000 on an initial investment of $1,500 and represents an increase in value of 233 percent!

COMPARE! If he buys the stock he will have a gain or loss of 50 percent whereas if he buys the option his loss might be 100 percent and his gain might be 233 percent. As a general proposition, the purchase of a call is considered far more risky than the purchase of the related stock.

Just as there are puts and calls on individual stocks, so there are puts and calls on broad market indices. Joan thinks the market is very undervalued but, not knowing which particular stocks are undervalued, she buys a call on the S&P100 index. Brian thinks the market is overvalued and he buys a put on the S&P100. Joan and Brian will both discover that index options are rather expensive.

Vicki has a broadly diversified and well performing portfolio of stocks. She thinks the prospects for further growth are excellent but she is troubled by the conflicting signals she is getting from her favorite guru, Allen Bluebroad. Ten years ago Bluebroad said the market reflected "excessive exuberance." Now with the market much higher he is talking about a "new paradigm" and that perhaps stocks are just starting to climb. Vicki knows that a characteristic of past bubbles is that just before they burst people who ought to know better get captured by the euphoria and lose their sense of perspective. (She has heard something to the effect that a once famous American economist, Irving Fisher, stated in the Summer of 1929 that the stock market had reached a new "plateau" from which it would never retreat.) She wants to get some insurance in case Bluebroad is mistaken and she accordinly buys a put on a broad index of stocks.

There is an important difference between options on specific stocks and options on an index. Options on specific stocks can be settled by a transaction in the stock whereas index options can only be settled in cash. Ernie, who bought the put on the hot technology stock, can deliver the stock to his broker and collect the $90 per share. But Vicki can't exercise her put on the S&P 100 by buying 10,000 shares of the S&P 100 and delivering it to her broker. What she can do, if the S&P has moved below the strike in her put contract is to demand that she receive the difference in dollars. That will compensate her in part at least for the decline in the value of her portfolio that may have occurred when the S&P went down.

Now you can:

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