In the Michael Lewis book The Big Short, investors Michael Burry, Steve Eisman, and Greg Lippman all foresaw the collapse of the US housing market and decided they needed a way to bet against it. But how do you bet against something like the US housing market?
The ‘short’ that the book derives its title from wasn’t an actual short-selling of any particular stock tied to US home values. Instead, Burry, Eisman, and Lippman purchased credit default swaps (CDS), a derivatives contract that would pay out should mortgage defaults rise. CDS contracts required payment upfront in the form of a premium, which acted like insurance on the mortgages. Once home prices declined, the value of the CDS contracts skyrocketed as banks and investors scrambled to buy them when homeowners began defaulting.
CDS contracts are derivatives, meaning their value is tied to the value of an underlying security. But how do derivatives work in relation to other securities and why are investors so apt to trade them?
What are Derivatives?
Derivatives have no intrinsic value – they’re just agreements between two parties saying that Party 1 will owe Party 2 if the price of XYZ reaches a certain point by a certain date. Derivatives can be drawn up and traded over pretty much anything: stock prices, commodity prices, interest rates, bond rates, and currency exchange rates.
For example, a derivative like a stock option will move in price depending on how the underlying stock does. If you own stock call options on Amazon (NYSE: AMZN) and Amazon’s stock price goes down, the value of your call options will go down as well. Since derivatives are contracts and contracts must have an expiration, the time left until the contract expires also plays a role in the price of the derivative. If our Amazon call options don’t expire until January 2022, they won’t be hit as hard as calls expiring in June of 2021.
Types of Derivatives
- Futures – One of the oldest and common forms of derivatives trading is futures contracts. Futures can be purchased on everything from oil and gold to stock indices and interest rates. Oil futures made headlines last spring when the price of the contract reached negative numbers: suppliers needed to pay to unload their product. Futures contracts can be settled in two ways: delivery of the underlying asset or a cash settlement.
- Stock Options – Options are exploding in popularity as a new breed of retail traders gain access to them through free brokers like Robinhood and Webull. An option is a contract based on the price of an underlying stock; call options are bullish bets on a stock and put options are bearish bets. All contracts are for delivery of 100 shares, meaning option buyers can control large positions with relatively little capital (known as leverage). But with leverage comes volatility and options can be risky vehicles if you don’t understand how they work.
- Bonds – Credit default swaps made Burry and company lots of money, but most of the time they’re used to protect against more mundane events like a ratings downgrade. Interest rates are another risk to bondholders, who often buy interest rate swaps to hedge against a sudden move in rates. Bond futures contracts are also traded on exchanges like the CME.
- Commodities – If you can trade it, you can likely buy derivatives on it and commodities futures are some of the most heavily traded derivatives on the market. In Trading Places, Eddie Murphy and Dan Akyroyd’s characters win big shorting orange juice futures, bankrupting the evil Duke brothers. Everything from oil to precious metals to softs like orange juice and cattle futures can be traded with derivatives.
- Currencies – Futures contracts also exist for currencies, which can be useful for companies that operate abroad and need to protect against changes in exchange rates.
Why Use Derivatives?
- Hedging – For many traders and institutions, derivatives are a way to hedge their investments in other securities or products. One of the most common examples is oil drilling firms. The process of locating, setting up, and drilling for oil is expensive and time-consuming, so oil drillers purchase oil futures contracts to lock in the price of oil for their drill. This way, if the price of oil declines while the operation is still drilling, the company can make up the lost revenue by cashing in their oil futures contracts.
- Speculation – As we’ve seen in the early stages of 2021, derivatives like options can also be used to place huge speculative bets. Far out-of-the-money (OTM) GameStop (NYSE: GME) options were bought by speculators during the February craze, but options have also been used to bet on high-flying tech stocks or against volatility gauges like the VIX.
- Leverage – While applying leverage can be dangerous, trading derivatives allows investors to increase their position sizes without expending extra capital. Buying a call option might only cost $30 to open, but could result in a 1000% gain if the stock surpasses the strike price well before expiration.
How Do Derivatives Trade?
Derivatives are priced through an entirely different process as stocks and they trade on different exchanges as well. The two types of derivative exchanges are:
- Regulated Exchanges – Trading takes place in the open on regulated exchanges like the CBOE and CME. These exchanges are governed by the SEC and must operate under certain rules.
- Over The Counter (OTC) – OTC trades are done outside of the lights of the exchange with no central authority figure making the rules. Trading derivatives OTC might give you access to securities not available on regulated exchanges, but the risks increase.
What Are the Risks?
- No intrinsic value – Because derivatives are contracts based on the price of some other underlying asset, they have no true value by themselves. A derivative will expire worthless if the agree upon price isn’t reached.
- Time decay – Since a futures or options contract has a defined expiration date, the value of the contract will decay at a faster and faster rate as the date of expiry approaches.
- Complexity – Derivatives require complex formulas to price since calculation must include not only the underlying asset price and the time until expiration, but also the volaility of the underlying asset and the rate of change of that volatility. Head hurt yet?
- Greater risk – Speculating on derivatives is riskier than traditional assets because volatilty and leverage are increased. If a stock declines 5% in a single day, you only lose 5% of your investment. But a call option on that same stock could be cut in half depending on the strike price and expiration date.
What are the Benefits?
- Price guarantees – Companies exposed to certain commodities risk like oil drillers use futures contracts to lock in oil price at the current rate. Bond investors use interest rate swaps to lock in a rate of return on their investments. Derivaitves are often used in conjunction with their underlying assets to smooth returns.
- Hedging – Investors can use derivatives to hedge their long or short positions in the underlying security, like buying a put option on SPY to hedge a long position during volatile periods.
- Leverage without margin – Traders without access to margin can still add leverage to their trades using options and futures contracts. Since an option is a contract for 100 shares of the underlying stock, a small price can be paid to control a large position. Executing an option will require enough capital to pay for the shares though.
Derivatives can be an exciting way to play the markets but remember these are contracts with no intrinsic value that are meant for trading and hedging, not usually long-term investing. When markets are volatile and you choose the right contract, you can reap profits far superior to those provided by traditional investments. But derivatives must be used carefully and new traders should be prepared for intense volatility and a few big losses when starting out.