3

As a small investor, there is a number of advantages to buying leverage derivatives instead of the actual stock:

fixed stop-loss

Once the KO barrier is hit, your money is gone - and you do not continue to lose as you would with actual stock. For instance, imagine the XY stock traded at 100€. You intend to trade it and set a stop-loss at 90€.

Case 1: You bought the stock.

It drops to 90€, stop-loss fires and you're selling at 88€. 12% lost. Or, it drops to 50€ over night - your stop loss is sad history now. In both cases, add trade fee for selling.

Case 2: You intended to risk 10%, so you buy a leverage product using 1 / (1 - 90%), equaling the 10% stop-loss of the money you intended to use.

The stock drops to 90€. You lost 10€, which is better than the 12€ (+fee) we had earlier. Or, it drops to 50€ - you also only lost 10€, which is a vast improvement.

Also, we cannot get in the psychological trap of lowering our intended limit "because I'm sure it'll go up again really soon!".

Ok, so if the stock drops, the leverage product is advantageous.

Same gain

What if the stock actually rises?

In that case, we gain exactly the same. For instance, let's assume the value rises to 120€.

In case 1 (actual stock), we get 120€ from 100€, i.e. +20€ which equals +20%.

In case 2 (leverage/KO), we get 30€ from 10€, i.e. +20€ which equals +200%.

In both cases, fee applies, though the derivative might possibly have a slight edge because it's lower volume.

Conclusion

So if we win, we win the same, and if we lose, we lose less. Clear case, isn't it? If it were the clear, why doesn't everyone follow this idea? Did I miss something?

I can think of two cases where the actual stock might be preferred:

  • You want to make use of the rights associated with the stock (for instance, enjoy dinner at their annual stockholder meeting). This might be important in some cases, but generally, I don't think this is very important.
  • You aim at the dividend paid. This is a special case. In case of stock that do not pay dividend, it does not apply obviously.

Apart from that, I can only see small amounts of money lost due to the additional cost of derivatives in general.

  • I think you need to clarify the assumptions inherent in defining how it is advantageous for a small investor to use leveraging derivative products. – fideli May 2 '11 at 23:42
  • @fideli: Advantage means more yield at almost same risk simply. Small investor refers to anyone whose actions do not have noticable impact on the market (i.e. close to all of us). – mafu May 3 '11 at 14:17
5

There's no free lunch. Here are some positions that should be economically equivalent (same risk and reward) in a theoretically-pure universe with no regulations or transaction costs:

  • (own the stock) = (buy call + sell put)
  • (own the stock + buy put) = (buy call + cash collateral)

You're proposing to buy the call. If you look at the equivalent, stock plus protective put, you can quickly see the "catch"; the protective put is expensive. That same expense is embedded in the call option.

See put-call parity on Wikipedia for more: http://en.wikipedia.org/wiki/Put%E2%80%93call_parity

You could easily pay 10% a year or more for the protection, which could easily eat up most of your returns, if you consider that average returns on a stock index might be about 10% (nominal, not real). Another way to look at it is that buying the long call and selling a put, which is a synthetic long position in the stock, would give you the put premium. So by not selling the put, you should be worse off than owning the stock - worse than the synthetic long - by about the value of the put premium. Or yet another way to look at it is that you're repeatedly paying time value on the long call option as you roll it.

In practical world instead of theory world, I think you'd probably get a noticeable hit to returns just from bid-ask and commissions, even without the cost of the protection. Options cost more.

Digressing a bit, some practical complications of equivalency between different combinations of options and underlying are:

  • options are quite a bit more expensive (both bid-ask spread and commissions)
  • individuals can't usually get the same margin rules and rates as say a hedge fund, which means some theoretically-equivalent positions are not (in practice one position may not be feasible)
  • in particular the lack of "portfolio margin" can make many positions infeasible
  • options are high-maintenance; they expire and have to be rolled, and they are hard to understand

Anyway, roughly speaking, any position without the "downside risk" is going to have an annual loss built in due to the cost of the protection.

Occasionally the options market can do something weird due to supply/demand or liquidity issues but mostly the parity relationships hold, or hold closely enough that you can't profit once expenses are considered.

Update: one note, I'm talking about "vanilla" options as traded in the US here, I guess there are some somewhat different products elsewhere; I'm not sure exactly which derivatives you mean. All derivatives have a cost though or nobody would take the other side of the trade.

  • I agree that, using options, the described approach likely breaks apart. I was referring to products similar to barxis.barcap.com/external/DE/2/contentStore.app?id=370381 ("Open Ended Mini Long Certificate"), preferably with strike very close to knock-out. When holding this kind of product with high or very high leverage (as explained in the question, 10% stop-loss equals 10x leverage), additional cost overhead does not appear to matter much usually. – mafu May 3 '11 at 8:54
  • There's just no way the cost of a protective option embedded in a derivative disappears; somebody is paying it somehow. Otherwise it'd be free money, and I'm sure Barclays isn't offering free money ... – Havoc P May 3 '11 at 13:52
  • That's true. For long term trades, the "time" component is sure to matter. For shorter terms though, it does not matter since the loss in time value is negligible and the person buying from you will have to pay the remainder. Meaning that you end up rather close to +-0 in that aspect. It would be great to see a close study on this topic though, I wonder what impact the effect you described has on different time scales. – mafu May 3 '11 at 14:13
  • For short-term trading I'd guess you don't lose so much time value, but you take a bigger hit on bid-ask and commissions. For US exchange-traded options you need a larger movement in the stock to make any money because of the spreads, compared to a smaller movement if you own the stock itself. And short-term trading of course involves more fees and spreads than buy-and-hold. But I can certainly see options having their advantages for trading purposes. – Havoc P May 3 '11 at 14:19
1

I am assuming you mean derivatives such as speeders, sprinters, turbo's or factors when you say "derivatives". These derivatives are rather popular in European markets. In such derivatives, a bank borrows the leverage to you, and depending on the leverage factor you may own between 50% to +-3% of the underlying value.

The main catch with such derivatives from stocks as opposed to owning the stock itself are:

  • Counterpart risk: The bank could go bankrupt in which case the derivatives will lose all their value even if the underlying stock is sound. Or the bank could decide to phase out the certificate forcing you to sell in an undesirable situation.

  • Spread costs: The bank will sell and buy the certificate at a spread price to ensure it always makes a profit. The spread can be 1, 5, or even 10 pips, which can translate to a the bank taking up to 10% of your profits on the spread.

  • Price complexity: The bank buys and sells the (long) certificate at a price that is proportional to the price of the underlying value, but it usually does so in a rather complex way. If the share rises by €1, the (long) certificate will also rise, but not by €1, often not even by leverage * €1. The factors that go into determining the price are are normally documented in the prospectus of the certificate but that may be hard to find on the internet. Furthermore the bank often makes the calculation complex on purpose to dissimulate commissions or other kickbacks to itself in it's certificate prices.

  • Double Commissions: You will have to pay your broker the commission costs for buying the certificate. However, the bank that issues the derivative certificate normally makes you pay the commission costs they incur by hiding them in the price of the certificate by reducing your effective leverage. In effect you pay commissions twice, once directly for buying the derivative, and once to the bank to allow it to buy the stock.

So as Havoc P says, there is no free lunch. The bank makes you pay for the convenience of providing you the leverage in several ways. As an alternative, futures can also give you leverage, but they have different downsides such as margin requirements. However, even with all the all the drawbacks of such derivative certificates, I think that they have enough benefits to be useful for short term investments or speculation.

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