Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Strategies & Market Trends : Booms, Busts, and Recoveries -- Ignore unavailable to you. Want to Upgrade?

To: Ilaine who wrote (4683)	6/10/2001 7:35:23 PM
From: Stock Farmer	Respond to of 74559

Hi CB - I like to think of derivatives like chain saws. Perfect tools for heavy cutting, but great pain occurs when they are unwittingly grasped by the wrong end. There's the rapidly spinning business end (the premium), and the handle end (the underlying capital). For example, instead of purchasing a stock, you can write an in-the-money put, hoping to be assigned. Your gains are capped if the stock takes off prior to expiration, but your losses are reduced if it tanks through a lower cost base. This is useful. Pain occurs if you write more puts than you would be comfortable buying (shares) outright. Similarly, instead of selling an equity you can write a near-term in the money call, hoping to have the underlying called away. Pain occurs when you don't have the capital to make good on the call. It's easy to forget that a $5,000 expenditure can end up tossing around half a million in capital. But there are situations where the risk can be completely contained and calculated up front. For example, maybe you are sitting on stock options that you want to exercise and hold through the long-term-capital-gains period... but you don't want to get caught out if the stock tanks. Well, purchasing a LEAPs PUT against your holdings at the time of exercise might be just the ticket to "lock in" a sure gain. When the holding period expires, you can choose to exercise your put or sell your stock. Lots of books useful here. You might try McMillan, "Options as a Strategic Investment". There are also some useful threads here: siliconinvestor.com Coping with tax issues and keeping abreast of margin requirements gives them a high PITA factor. And finally, this is only the novice side of the whole derivative scheme. The big guys get into some pretty kinky stuff, although the principles remain the same: NPV of risk can be calculated, factored, purchased and sold. In the end, it's all buying and selling of promises. As you correctly pointed out, the problem arises when there are calculably more promises than can be made good. Margin merely exacerbates this problem. John