BusinessWeek, just put my subscription on hold

Cooper's article again lacked any whiff of rational thought and underlying facts to support his thesis but an even more egregious article was penned by Ben Levishon and Mark Scott. (Editor's note: don't click the link to the article unless you want some cheesy advertisement to queue up and start playing. WTF is that?) I imagine the penning of this article took place after a long three martini afternoon at the Delmonico.

I won't bore you with the details of the article but here is the handy dandy chart (which I had to re-create because they don't include it in their online article version. Seriously, WTF?)

Notice damage, pay extra, fewer choices, cost rising.

Notice now: may affect, may ..., could rise

So based on something they overheard while watching a monkey wrestling match at Delmonico even then they could not bring themselves to state that these reforms will actually affect any pricing. "I don't know what we are yelling about... Loud Noises!!"

Derivatives
They did find a partner whose firm represents JP Morgan Chase, ABN Amoro, Barclay's and BNP Paribas to state "it won't make it any easier for companies and investors to dig out of the recession." So they quickly put that in their sub-head on their collateral damage chart, except the editor made them add the caveat "may."

The authors then pen this gem "Credit Default Swaps - blew up, prompting huge loses at insurer American International Group and other companies. The reforms are meant to prevent another disaster." The thing is though, they did not blow up, in fact CDS's were the only market actively trading during the entire crisis. What did happen was that AIG posted no collateral for the CDS trades they initiated. They "wrote" these contracts meaning they would take in premium periodically over the life of the contract and if the underlying security defaulted then they would have to pay out.

Well some of their contracts triggered and then they need to pay those claims out. Then their counterparties demanded that they start posting collateral for CDS they underwrote. This created a $180 billion dollar hole in AIG's balance sheet almost over night. It was not the instrument!! It was that unlike contracts that trade at the CME, the Merc, NYMEX where you have to post collateral when contracts go against you, there was no action you could take against AIG until it was too late, thus the run on the company.

The authors continue "Exchange-based derivatives cut into cash reserves. Under current requirements, companies have to fork over 3% of a contract's value as collateral up front in case the transaction goes south." Well, we already talked about that above. Their argued flaw is actually the enhancement that will prevent AIG-type companies from blowing up!!! Avoiding collateral charges because of their AAA ratings is not reasonable. This idea ensures that counterparty exposures can be nipped in the bud when companies bet wrongly in the derivative markets.

So there goes one of the boys arguments.

"The changes could also make derivatives a less effective tool for controlling expenses. Derivatives sold over the counter are tailored to a company's individual needs, while exchange-traded contracts are standardized."

The regulators are treading lightly. They want safety for the financial system, but also not to deter consenting adults from making contracts. The hope is to move CDS contracts to the exchanges where there are more safeguards. Thus far, regulators only want to move standardized contracts to the exchanges. Tailored CDS solutions will still be allowed if that is what a client needs. However, it will be out in the open and very transparent that companies will take on a huge counterparty risk if it chooses a non-exchange traded contract.

Another one bites the dust and now for the nail in the coffin.

Here is the real reason the shills are heading their masters' calls. From Satyajit Das "Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity. The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible."

Commodities
From the article, "In light of the changes, financial firms are pulling back on some commodity offerings for small investors...Barclays Wealth recently told high-net-worth clients to ditch exchange-traded funds that focus on commodities in favor of hedge funds and other alternatives that invest in this area."

This is probably a sane idea as well from Barclays. There is a must read article from David Merkel about investors in Commodity ETFs are being snookered.

Here is the money quote for those short on time. "One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple. “Buy the front month futures contract, and roll to the second month contract before the front month expires.” Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy. So, what do the other investors do? They take the opposite side of the trade early, in order to make it more expensive to do the roll. Buy the second month contract, and short the first. As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract. What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market."

Too bad, so sad. No real problem there accept small investors may be better protected from ETFs that do not work as advertised.

Oh no the dread of all publishers who publish an honest-to-god hold-in-your-hand periodical, there is only two paragraphs left!!!!

High-Frequency Trading

"The technique [high-frequency trading] has been controversial of late as big trading firms have booked billions in profits while their clients' portfolios have dwindled."

The Daily Show With Jon Stewart	Mon - Thurs 11p / 10c
Cash Cow - High-Frequency Trading
www.thedailyshow.com
Daily Show Full Episodes Political Humor Ron Paul Interview

Well that was fun but seriously HFT is not a bad thing. It's much worse.

Commissions have gone down for trading. The spread may have lessened as Professor Lo points out. However, someone is paying for the spread and it is the retail investors. Now, back in the old days there was a market maker and he took the spread. He has now been pushed aside by the HFT supercomputers since they both perform the same function. However, investors and traders were willing to pay the spread to the market maker for liquidity. So when you bought the market maker sold; if you sold he bought. With the HFT there is no guarantee or onus of guaranteeing liquidity. If the bots do not want to play no one can make them. Thus, liquidity can be withdrawn from the system overnight and liquid positions may not be based on the, relatively [may be this is a mixed metaphor], solid pillar the trader believes them to be. There is a lot of information at this website.

So all in all not bad for BW, they missed on all three accounts.

Answer to Options Uncovered

A July European call sells for $4.70 and the strike price is $95. The stock last traded today at 94. An investor is trying to decide whether to buy 20 call contracts or buy 100 shares, both scenarios cost the same amount. Under which scenarios is the option strategy more profitable, the stock, when are they equivalent?

I drew the graph for you charting the Profit/Loss potential for both the option and the stock strategy. You can see that the loss rate is severe for the options, meaning if the stock does not move up and quickly the option will expire and you will be out the $9,400 in premium. However, once the stock moves above 100 the benefit of leverage comes into play and the upside is also more severe as well. The two strategies are equivalent at a share price of $100.

I would not guess that most clients would go after the call options because there are only 14 more trading days until expiration and the stock would have to move 6.38% up to equal the stock strategy. However, if this option were further out like an October call this might be a reasonable strategy.

Options uncovered

I was recently reading an article in Fortune magazine about derivative contracts. It hilariously made reference to the 1st derivative contract being contrived around 1994. Well, let me quote directly. "In a 1994 cover story by this writer (Carol Loomis), Fortune called derivatives, then relatively new on the scene, "The Risk That Won't Go Away." Knowing this was not true but not knowing when the first derivative contract "appeared on the scene" I Googled it. Lo and behold Aristotle wrote about them in his seminal work Politics. This recorded work was said to have been writing around 350 years before the common era.

There is the anecdote of Thales the Milesian and his financial device, which involves a principle of universal application, but is attributed to him on account of his reputation for wisdom. He was reproached for his poverty, which was supposed to show that philosophy was of no use. According to the story, he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort.

Apparently arriving on the scene in Loomis' meaning entails a period of twenty-three hundred and forty-four years. It must be quite the scene for the party to keep going on that long. I digress.

So I wanted to go over derivatives including options, then futures and finally dreaded credit derivative products. Because we must crawl before walk and walk before run, this may take a post or two dozen.

Options come in two basic varieties that can be combined in countless ways to hedge or speculate in the capital markets. The two basic types are call and puts. Now sense these securities are contracts they are very carefully worded. So here it is:

1. Call option - the right to buy an asset by a certain date for a certain price
2. Put option - the right to sell an asset by a certain date for a certain price
   

Easy, right? Well there are a couple more moving parts, which is where everyone gets wound up. There is the strike/exercise price. This is the certain price. Then there is the expiration date or maturity which is the certain date.

Not so bad. Well, here comes the kicker. The option is a right but just like the American voter who has the right to vote does not mean he will show up to vote. Thus, an option purchaser may not exercise the right. All American options, at least the ones on exchanges are for 100 shares. One last thing, there is still the current price or the spot price, which is what the asset is currently worth. Now for an example.

Today is June 29, 2009 The SPY ETF which mimics the S&P500 currently sells for 92.70. The July 2009 contract with a 93.00 strike price sells for $1.62. So if today you wanted to buy the option you would contact a broker, he would find someone to sell a call and then you would pay 162 dollars. This payment gives you the right to purchase the 100 shares of SPY by July 17th.

So two things can happen, either the option is worth money or it isn't come July 17th. If SPY has been bid up to 95 dollars. Then you could use your option right to buy 100 shares of SPY at 93.00 and immediately sell them in the market for 95.00 Gaining 200 dollars. Then you would figure your net takeaway is 38 dollars because it cost you 162 dollars to set up the contract. On the flip side if SPY is at 94.62 or less it would not make sense for you to exercise your option. That is at 94.62 your gain on the sale once you exercised the right would by 162, less the fee to purchase the contract you are at zero. So you do not exercise the option contract.


Now why would someone do this instead of just purchasing the shares outright? There are countless reasons but the most simple explanation is leverage. You only used 162 dollars to purchase an investment that was worth 9,270 dollars in today's market.

The same is true for puts. This time you instead have a hunch that the market is going to fall in the next couple of months. So instead you buy a July put on the SPY ETF with an expiration price of 90.00 for $0.98. So on July 17th the SPY is trading at 85 dollars. You had sent your 98 dollars to the broker on June 29th and now you can sell SPY shares for 90 dollars when the market is trading them at 85. So two things can happen, either you already own a lot (100 shares of SPY) as part of your market portfolio and you just complete the transaction. Or you can buy the shares and add it to your portfolio now at 85 dollars and sell them. Either way you make 500 dollars on the trade and net out the cost of the contract which was 98, so final total is 402 dollars in profit.



Finally, there are two more positions a person could take with these options, which is selling them. An easy example is insurance. I own 1000 shares of Google (GOOG,) but I think the US government may enact anti-trust litigation against them. Thus, I want to insure my portfolio. You look at the case and decide that there is no way the US government will act on such flimsy evidence. You in fact own GOOG stock as well, to enhance your holdings you sell a put to me. That is, I pay you an upfront premium in case the stock falls. If the stock does not fall, or doesn't fall enough, then you picked up free premium plus you still own the stock and its dividend rights. However, the downside risk is steep. If GOOG did start dropping you would end up doubling down at a time when the majority of stockholders are selling.

The other side is the selling of calls. Just like puts, most calls are never exercised. Thus, if you think that MSFT is not going to appreciate in the next month, then you can sell a call, take the premium and sleep peacefully. Of course ...

Here is a quick homework example and I will post the answer up tomorrow.
A July European call sells for $4.70 and the strike price is $95. The stock last traded today at 94. An investor is trying to decide whether to buy 20 call contracts or buy 100 shares, both scenarios cost the same amount. Under which scenarios is the option strategy more profitable, the stock, when are they equivalent?