Is this a "don't try this at home" move, or can it be done by regular folks? It sounds very lucrative if done right, but I can't seem to get straight answers on just how to do it right so I haven't tried it.
Any advice or resources?
Is this a "don't try this at home" move, or can it be done by regular folks? It sounds very lucrative if done right, but I can't seem to get straight answers on just how to do it right so I haven't tried it.
Any advice or resources?
"She has written so well, and marvellously well, that I was completely ashamed of myself as a writer...But this girl, who is to my knowledge very unpleasant and we might even say a high-grade bitch, can write rings around all of us who consider ourselves as writers"
Ernest Hemingway on writer, aviation pioneer and horse trainer Beryl Markham




- For me personally, not a chance in hell. I wouldn't be able to sleep at night.
- For someone who manages their portfolio full time, maybe.
- For a trader who never goes home with something open, then definitely.
The two biggest problems I have are:
1) You're not going to hold them long enough, so it will be taxed as regular income.
2) My main reason is unlimited downside potential. There is no limit to how much you can lose shorting a stock, and I do not wish to rely on a stop loss to save me.
I know that's a very simplistic approach to it. It's not accounting for many more advanced strategies.
NinaDaisy, PM me if you would like to discuss.
Lunchbox...assuming you weren't too risk-averse to short, why not have a stop-loss to protect against downside?
I won't do it for my clients. If they want to do it themselves, they can sign the margin disclaimers and do it themselves through brokerage........
"Have you ever been to American wedding? Where is the vodka, where's marinated herring?" - GB
"And do the cats give a shit? No, they do not. Why? Because they're cats."-from The Onion
Originally Posted by Mia M







If you don't have the time to spend managing your portfolio, you probably shouldn't be going short. It takes effort and time and needs your attention. The less attention you can offer, the higher risk it will become.
If the topic generally interests you though, you should hunt out some of Harry Schultz's books. The books are broadly about bear markets, I think he has written five or six about the topic and he gives some useful info on how and when. The books aren't new or necessarily up to date, but you will get a good grounding.





I would also add that direct and actual shorting of stocks is even a bit risky for my tastes. Assuming that not everyone may understand the actual details of the 'shorting' procedure, it means that you must borrow shares in a given company from your broker , you then sell the shares today at price X, you pay 'rental' charges' on the borrowed shares that you no longer have, and eventually you must go into the stock market and buy back an equal number of shares in the same company at price Y to replace the shares you borrowed. If X is significantly higher than Y you make out like a bandit. However, if Y is higher than X, you're in big trouble, particularly if speculators manage to push the current share price sky high (see Krispy Kreme last year), because you're obligated to pay however much it costs in order to buy back shares to replace the ones you borrowed.
However, it is possible to achieve similar results by other, less risky means. One of my favorites is to buy put options on shares of a given company at price X, with the strike price being on the low side 'edge' of today's share price (meaning that the options contracts are relatively cheap). Then if the share price falls significantly, the value of your options contracts can rise significantly. However, if the share price inexplicably rises, the downside worst case on your put options is that they expire worthless thus you lose exactly as much as you paid for them ... no more.





^^^ true re the zero sum game. However, there are certainly enough Joe Sixpacks out there whose 401k mutual funds own trillions of $$$ worth of shares that you don't need to beat the 'best and brightest' in order to profit from put and call options !!!! Ultimate no-brainer example of course is 6 month put options in homebuilder stocks !




You cannot compare the players in an equity market to those in derivatives.





^^^ well, arguably you can make such a comparison if you're only talking about a put or call option on stock shares of one specific company or a certain quantity of a certain commodity. In this case, there was an option seller who actually owns those stock shares or that commodity, and a counterparty option buyer. This arguably constitutes a 'simple agreement' between two parties over one actual asset which one party already owns and has full control over.
When the term 'derivatives' is used, to me at least this implies a complex agreement between two parties which is triggered by / based on financial variables which are far beyond the control of either party and which neither party 'owns' i.e. an interest rate, a currency exchange rate, an index based on the market price of 500 different stocks etc. Where stock / commodity options represent little more than an agreement on terms of a future sale of that stock / commodity, 'derivatives' are more akin to insurance or to outright gambling.
I agree that these days the additional (and IMHO unwarranted) risk has crept into stock and commodity options ... but the root cause of that extra risk is the fact that large financial institutions are allowed to get away with 'naked shorting' (i.e. illegally selling or promising to sell stock shares or quantities of a commodity which they don't own and haven't legally borrowed / leased). Even so, this is a far cry compared to contracts which are little more than Las Vegas bets on future Fed interest rate policy, future US Treasury US dollar exchange rate policy etc. - in which case the 'professionals' who have an inside track to the Fed and Treasury do have a clear advantage over the 'little guy' !




You're wrong. An option need not be backed by ownership.
Derivatives to me are anything derived from an Equity. You're making a few incorrect assumptions about who owns what.When the term 'derivatives' is used, to me at least this implies a complex agreement between two parties which is triggered by / based on financial variables which are far beyond the control of either party and which neither party 'owns' i.e. an interest rate, a currency exchange rate, an index based on the market price of 500 different stocks etc. Where stock / commodity options represent little more than an agreement on terms of a future sale of that stock / commodity, 'derivatives' are more akin to insurance or to outright gambling.





so, by your definition, an interest rate swap contract isn't a derivative ? What the hell is it then ? In fairness, there are many different definitions for derivatives - and the one that best fits interest rate contracts simply involves variance with time.Derivatives to me are anything derived from an Equity. You're making a few incorrect assumptions about who owns what.
well, at least until the LME changed the 'rules' after the fact, and to date on US stock and commodity exchanges, options contracts are backed by 'implied' ownership at least ... in the sense that the option seller must own (or buy at market price in order to own) the underlying commodity / shares in order to fulfill the contract if and when the option they previously sold is exercised.You're wrong. An option need not be backed by ownership
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Last edited by Melonie; 12-01-2006 at 04:24 PM.




I don't see how you got that from what I said. All derivatives have underlying equities, which is what they are derived from.
There is no need to make this about an exception.well, at least until the LME changed the 'rules' after the fact,
There is no such thing as 'implied' ownership.and to date on US stock and commodity exchanges, options contracts are backed by 'implied' ownership at least ... in the sense that
What about this is "implied" ownership, it is just how the system works.the option seller must own (or buy at market price in order to own) the underlying commodity / shares in order to fulfill the contract if and when the option they previously sold is exercised.





^^^ well, basically, YOU invoked the LME exception ... because this was the only time that the option sellers' 'implied' ownership requirements of the underlying commodity were waived. If you'll remember, last August a number of big players had sold futures contracts on LME nickel without actually owning the metal. When those futures contracts matured, and the futures contract sellers were then required by the terms of those contracts to become owners of the metal (i.e. purchase it at spot market prices) in order to subsequently deliver the nickel to the buyers of the futures contracts that they had sold, the option sellers were looking at incredibly huge losses (as spot market prices of nickel were astronomical due to very short supplies). Thus the LME waived the 'implied' ownership requirement i.e. the exchange declared that it was not necessary for the contract sellers to actually become owners of the nickel in order to deliver it by the contract date, but instead declared that the contract sellers could continue to pay 'interest' to the contract buyers in lieu of owning and subsequently delivering the metal to the futures contract buyers !!!
Hopefully this serves as a graphic example of the 'implied' ownership requirement I am talking about. The LME nickel exception aside, every futures contract or option contract carries an 'implied' ownership requirement i.e. that the futures / option contract seller must own the shares / commodity the contracts were written on at the time the futures / option contract date arrives in order to make the required delivery to the futures / option contract buyer. Granted it is not necessary to own the actual shares / commodity at the time the futures / option contract is first written, and granted that it is not necessary to own the actual shares if the option contract expires out of the money or the futures contract owner requests a rollover rather than physical delivery - but it IS necessary for the contract seller to own the actual shares if the stock option is exercised and the buyer requests delivery of the shares, and it IS necessary for the contract seller to own the actual commodity when the futures contract expires and the buyer requests delivery of the commodity (or at the very least it is necessary to officially 'borrow' said shares or commodity from someone who does actually own them, and replace them later). Arguably, it is this 'implied' ownership requirement that maintains a linkage of financial reality with the spot market price of the underlying stock and commodity (as opposed to illegal 'naked shorting' artificially depressing that spot market price).
I'm still not buying this definition ! What is the underlying equity for these derivative contracts ? snow and ice ?I don't see how you got that from what I said. All derivatives have underlying equities, which is what they are derived from.
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Last edited by Melonie; 12-02-2006 at 03:23 AM.
It's not like there's any alternative definitions or even any academic debate as to what constitutes a derivative instrument. It's simply a claim whose value is contingent on the price of one or a number of other instruments. For that matter, a bond is a derivative as well.





OK OK in a technical sense anything that does not involve direct and immediate transfer of ownership at point of purchase / sale qualifies as a 'derivative'. But there is also a distinction between financial instruments which carry 'implied ownership' requirements on the part of the seller (i.e. bonds, stock and commodity options, commodity/currency futures) and financial instruments that don't (i.e. swaps, lookbacks, 'intangible' futures i.e. weather and interest rates etc.), with the latter carrying much higher levels of risk.
I fail to see the distinction with respect to "implied ownership" you are trying to make. What happens at expiry or the time of exercise is solely governed by the derivative instrument's payoff function which constitutes part of the contract specification/term sheet. If you don't want to hedge there's no need to own or transact in any underlying instrument before expiry/exercise and even then only if the contract prescribes settlement in the underlying.
As for your examples, how does a vanilla stock/commodity option "imply" ownership while a similar lookback option does not? The only difference is in the payoff function with the latter's being path-dependent. And at least from a historical perspective of how the instrument was conceived as a strategy to mutually lower borrowing costs an interest rate swap does not "imply" any less ownership than an outright bond position does. After all it is nothing more than the agreement of two counterparties to exchange two bond generated cashflow streams of different makeup (fixed/floating).
As for risk, the level of risk embedded in a derivative instrument does not depend
on the level of "abstraction" of the underlying but at least for vanilla contracts solely on the underlying's volatility and the gearing as defined by the specific parameters of the derivative. In practice, the notion of risk only makes sense when evaluating a complete portfolio taking into account correlations/hedge positions (see Value at Risk, RiskMetrics etc.)





margin calls on commodities are actually further proof of the 'implied ownership' concept ... i.e. the 'lender' becoming disturbed that the investor will be unable to meet the 'implied ownership' requirement attached to both their own invested money as well as the 'implied ownership' requirement attached to the lender's 'borrowed' money that has been similarly invested.For the love of god, get over the implied ownership concept. How about margin call?
You have actually answered the entire question line - thank you ! The difference is that 'vanilla' options (which is a very good term to describe the distinction I have been trying to make) do require that settlement actually be made in the underlying stock or commodity, whereas more 'abstract' derivatives only require settlements in cash. Therefore, in theory at least, the number of 'vanilla' options that can be written on a given stock or commodity, and the pricing of those options as well as the market pricing of that given underlying stock or commodity itself, are intertwined and limited by the amount of given stock or commodity which is actually in existance / available for sale or purchase on the spot market by that very requirement of (potentially at least) having to make physical delivery of the underlying shares / commodity upon contract expiry. This is what I was referencing in terms of 'implied ownership' ... that in order to satisfy the physical delivery requirement it is implied that the contract seller must 'own' the underlying stock or commodity at the point of contract expiry in order to deliver the shares / commodity itself to the contract buyer.If you don't want to hedge there's no need to own or transact in any underlying instrument before expiry/exercise and even then only if the contract prescribes settlement in the underlying.
As for your examples, how does a vanilla stock/commodity option "imply" ownership while a similar lookback option does not?
But more 'abstract' derivatives have no such direct linkage to the 'real world', thus the pricing of such derivatives is arguably based more on 'faith' more than on 'fact' (with 'faith' referring to what the counterparties 'think' they are worth in the absence of a 'factual' real world pricing yardstick as can be applied to 'vanilla' derivatives). Thus the increased risk which is arguably inherent in 'abstract' derivatives stems from the possibility of that 'faith' being severely shaken by some stressful real world event / change.
As I am not formally trained in the finer points of financial engineering, and as I seem to have difficulty conveying my intuitive point unless I can put it into generally accepted buzzwords, I had to do some research to come up with the generally accepted buzzword which applies to what I am trying to say here ... which is 'volatility skew' ... . The fact that price volatility factors heavily into all valuation formulas for 'abstract' derivatives, plus the fact that those valuation formulas all make use of 'idealized' volatility assumptions which sometimes don't hold true in the 'real world', has already given birth to a long list of alternate theories / exceptions / models which attempt to explain past abberations and predict future abberations. My point is that, despite the improvements of Black-Scholes modeling to 'jump diffusion' modeling to 'mixed distribution' modeling, the 'real world' holds the potential for far greater 'volatility surprises' than any of these fancy formulae have been able to encompass so far - thus the holders of 'abstract' derivatives are actually exposing themselves to greater risks than these imperfect pricing models reflect.
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Last edited by Melonie; 12-03-2006 at 10:30 PM.
Margin requirements don't have anything to do with ownership 'implied' or otherwise. They are simply a mechanism employed by clearinghouses to mitigate counterparty risk and cover their own behind as they are the guarantor of the trade. If you trade an equivalent product OTC instead of through an exchange there won't be any cashflow/margin requirements before the contract becomes due.
Wrong. And you don't have to look any further than a simple SPX call/put, a vanilla option that is cash settled, to have an example to the contrary. With respect to options, vanilla just means a generic call or put payoff function as opposed to exotic contracts (e.g. barrier, asian, chooser, basket options etc.) that have path-dependent features, or are of higher order. It does not imply anything about the mode of settlement.You have actually answered the entire question line - thank you ! The difference is that 'vanilla' options (which is a very good term to describe the distinction I have been trying to make) do require that settlement actually be made in the underlying stock or commodity, whereas more 'abstract' derivatives only require settlements in cash.
Why? He can just short it to him on assignment (naked, standard DTC procedure with equity options if the assigned account cannot satisfy) after which has three business days (T+3) time to deliver be that by locating a borrow or purchasing in the open market. Of course, if he fails to do so, his broker will eventually execute a forced buy-in. But all of that can easily be avoided simply by rolling over or liquidating positions ahead of expiry.This is what I was referencing in terms of 'implied ownership' ... that in order to satisfy the physical delivery requirement it is implied that the contract seller must 'own' the underlying stock or commodity at the point of contract expiry in order to deliver the shares / commodity itself to the contract buyer.
Give an example. If there's no consistent asset or index price model for the underlying then by definition there cannot by a valuation model for any derivative on it. Hence, there won't be a derivative product in the first place as no rationally acting person would trade it.But more 'abstract' derivatives have no such direct linkage to the 'real world', thus the pricing of such derivatives is arguably based more on 'faith' more than on 'fact' (with 'faith' referring to what the counterparties 'think' they are worth in the absence of a 'factual' real world pricing yardstick as can be applied to 'vanilla' derivatives). Thus the increased risk which is arguably inherent in 'abstract' derivatives stems from the possibility of that 'faith' being severely shaken by some stressful real world event / change.
Volatility factors into any non-linear derivative valuation model (pretty much everything except forwards, futures, and swaps). If something has zero volatility, it does not move, and thus does not have any value beyond time value. The degree of volatility sensitivity/risk generally is not a function of the degree of complexity or 'abstraction' of an instrument. E.g. if you happen to have a significant model tracking error with respect to volatility a vanilla european equity call will be just as much affected as a knock-out barrier call or asian call with bermudan exercise.My point is that, despite the improvements of Black-Scholes modeling to 'jump diffusion' modeling to 'mixed distribution' modeling, the 'real world' holds the potential for far greater 'volatility surprises' than any of these fancy formulae have been able to encompass so far - thus the holders of 'abstract' derivatives are actually exposing themselves to greater risks than these imperfect pricing models reflect.
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In practice the market only relies to a limited extent on Black-Scholes to price contracts as evidenced by the existence of volatility skews of the vertical (smile) and horizontal variety. In a pure Black-Scholes world with constant volatility, volatility skews by definition could not exist. In situations where the impact of non-normal return distributions is of particular concern, stochastic volatility surface models derived from GARCH flavor stochastic processes can be employed to approximate and take into account the specific, typically leptokurtic, deviations of returns from a normal distribution. Pricing with such models usually has to be done using Monte Carlo simulations, so the computational effort is substantial compared to simply plugging values into closed-form Back-Scholes, numerical solution using finite difference methods, or pricing american contracts on a binomial or trinomial tree.
I agree with Susan that the theoretical volatility (and risk) of a derivative has nothing to do with how it settles. I don't really know how you could measure the "risk" of an individual derivative (versus the margin requirements for a future? versus the full size of the underlying?) so I'm not sure it would be easy to argue that the universe of physically-settled derivatives is more or less volatile than the universe of cash-settled ones.
"All this time you were pretending
So much for my happy ending."
--Avril Lavigne
In practice quantifying derivative risk is done at the portfolio level, typically through some sort of Value at Risk methodology that calculates the maximum expected loss for a certain time interval within a specified confidence interval. This can and should be complemented with crash scenarios that take into account breaking down of correlations and liquidity issues.
As for a single fully unhedged derivative contract, a risk profile is given by its sensitivites to its pricing dimensions (input variables and parameters). So for a non-linear derivative like a vanilla equity call option you have to differentiate between directional risk as expressed by delta and gamma (first and second derivative of the option value with respect to the price of the underlying), volatility risk (vega), time risk (theta), and interest rate risk (rho). The latter two being independent of the underlying.
Meonie, I get your idea of 'implied ownership' in terms of simple strategies like replacing ouritght equity positions with deep ITM calls etc. However, this notion of 'implied ownership' is not a generally employed concept to classify derivatives nor is it a sensible criterion for distinguishing among riskier and less risky derivatives as it does not influence the risk profile as determined by the valuation model input variables and parameters.
Also, discussing systemic risks solely with respect to the characteristics of a certain class of derivatives does not make any sense unless you have precise knowledge of the proportion of open contracts in the market that are unhedged.





^^^ Well you guys definitely have more formal knowledge on the subject of derivatives than I do. However, my common sense and instincts tell me that the farther removed a derivative is from its underlier (if there is in fact an underlier with its own tangible value), the more likely it will be that an unexpected financial 'event' of some kind could upset the proverbial apple-cart. I'll stick to my 'vanilla' puts, calls and futures for the time being and leave the more 'abstract' derivatives to those with more knowledge, more research capability, and more risk tolerance.
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