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If I have information that an asset will increase or decrease in value, I can profit on that information by buying or shorting the asset. Why, then, would anyone trade derivatives when they can just profit by directly trading the asset? How does this work from a theoretical perspective (game theoretic, etc)? This is a very simple question, I'm not sure if this is the right place for it, but thought I would try asking.

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  • $\begingroup$ Well you own the asset if you buy it, but you don't have to acquire it with a derivative right? So the latter seems more convenient if you're just trading. $\endgroup$ – VCG Aug 29 '16 at 0:54
  • $\begingroup$ Shorting the asset is a derivative product. $\endgroup$ – Giskard Aug 29 '16 at 10:06
  • $\begingroup$ Long Term Capital Management made a fortune in convergence trading of derivatives (en.wikipedia.org/wiki/Convergence_trade) before losing it all again in spectacular fashion. $\endgroup$ – Ubiquitous Aug 30 '16 at 9:38
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    $\begingroup$ Would you like to take delivery of 20 tons of live cattle? $\endgroup$ – Henry Aug 31 '16 at 18:40
  • $\begingroup$ Does this answer your question? Are options a form of insurance? $\endgroup$ – NNOX Apps Aug 23 at 5:34
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There are number of reasons to use derivatives. How practical the following are? It, in turn, depends on the costs compared to the importance (utility) of the case. The costs can be substantial.

  1. Hedging purposes, which comes in many forms. E.g. when you buy stocks in foreign currency, you may want to take only the equity risk, not currency risk. Or you buy a fund or etf that comes with country or industry risk that you want to get rid off. Or you believe equity in the long run but don't like the volatility, so you (try to) hedge volatility away.

  2. Limit controlling. E.g., if you are working in asset management industry and take care of funds of customers, the portfolio should have set limits: the derivatives may give you an easy way to comply with limits ("you are happy with the instruments you have chosen to your portfolio and want to keep them but without derivatives, say the minimum amount of equity risk would not be attained").

  3. Leveraging a (sub-)portfolio. "Sometimes you cannot apply loans. But want to have more exposure than is otherwise possible."

  4. Bearing a particular type of risk, e.g., you may believe that volatility is going to increase from the current level. This particular example can work as a hedge to your portfolio at the same time, since usually the increase of volatility means that portfolio performs badly. Moreover, this is an example of risk that is hard to get in to your portfolio without derivatives.

  5. Quick change of allocation for tactical reasons. Say, evolving crisis either forces you to move quickly, e.g., because of limits as in case 2, or because of the capacity to bear risk (economic reason). And this case includes also the panic moves.

  6. Sometimes, there are other motives behind applying derivatives that somehow build upon the first four cases. E.g. you have a complex company structuring case in your hand and you may have to transfer particular types of risk from one party to the other. To the other this is hedging and to the other risk taking: the derivative use could be classified to be "enablers" of transactions.

  7. In the spirit of previous case, derivatives can be used in product design. E.g. some hedge funds promise to apply certain derivatives strategies. These products (hedge funds) may be targeted to professional investors and retail customer. Another example include index loans, typically marketed to retail customers, and may include exotic derivatives like binary options where the underlying is determined e.g. by the month end values of the last 12 months for a basket of securities. The motivation for options reduces to the first one listed above (hedging): the index loan may include a promise ("a guarantee") that, say 95% of nominal will be preserved in every possible scenario to be faced. So hedging appears to be provided to customers.

  8. "Personal characteristics" like willingness to gamble may apply as reason. These may reduce to the third item.

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Here's a very practical example:

Case 1: Say I have a stock worth \$50 bucks that is relatively stable but fluctuates by a dollar or two every day. I buy a 50 call options (the right to buy it) at \$55 for 1.00 each. The next day I find to my surprise the stock has risen to 57 dollars. I cash in all my options for the price of 2.00 each (57-55).

I had 50.00 to invest, I bought 50 options, cashed them in for \$100, net gain of \$50.

Case 2: Alternatively, I could have bought a single share. If it rises to 57, I have made \$7.

Summary: Options have much higher possible returns. Note in case 1, if the price had only risen to \$54, the options would be worthless. Such is life.

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People trade derivatives because they believe that they will be better off if they do trade them, than if they don't.

There can be lots of different reasons for that belief. Here are some.

  1. For many day traders, it's simply because they're deluded. It's an erroneous belief, brought about by a combination of various cognitive biases: over-confidence in their own judgement; only looking for evidence that supports their prior beliefs; believing that their wins are a result of internal factors (e.g. their own judgement) whereas their losses are a result of external factors (e.g. it was an unlucky day, or freak circumstances acted against them); and so on.

  2. They have a loss function (cost function) that's sufficiently different to the rest of the market, so that they don't need to beat the market, in order to improve their returns by the standard of their own loss function. Perhaps they already have exposure to the underlying instrument, and need to hedge off some of that exposure; for example, a company that has its income in one currency, and its outgoings in another, may want to hedge the exchange rate between those currencies.

  3. They want to gamble for the reward of gambling, and derivatives offer an appealing combination of leverage and exposure. This may represent some combination of (1) and (2).

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  • $\begingroup$ If we take your first reason to be truthful, your answer is automatically incomplete. Fish attract sharks. $\endgroup$ – user7935 Sep 19 '16 at 17:12
  • $\begingroup$ @Timo the trouble is that most of those fish think they are sharks. Dunning-Kruger fish, if you will. $\endgroup$ – 410 gone Sep 19 '16 at 18:27
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Derivatives provide the investor a way of transferring risk. Plain and simple. They are incredibly complex if you want to get into them, but there's your answer.

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