We use derivatives to turn uncertainty into known quantities. Yes, we used a financial dirty word, but derivatives used correctly can help portfolio construction on multiple levels.
Derivatives, think options and futures, have been used for centuries to do just one thing – reduce uncertainty. This can be done through hedging (reducing uncertainty in a position) or through making investments with potential risk quantified.
Hedging – At the individual security level, we can completely hedge all or a portion of a position. We don’t do much of this, but for concentrated positions it’s a great solution to control outsized risk.
Defining Risk – As long term investors, we are always looking for return and trying our best to understand and get comfortable with the risk associated with that return. Derivatives allow us to not only understand potential risk, but define that risk exactly, while still allowing for potential upside. Here’s an example:
Let’s say we like AAPL, which is currently trading for 187.23 as I type, and we’d like to buy 100 shares. Our total investment, if we bought the stock outright, would be $18,723. We are hopeful for upside return and by owning the shares we have potentially unlimited potential. What we don’t know, is how much risk is involved. While I don’t think AAPL’s going out of business anytime soon, technically our entire investment is at risk.
We could turn to the derivatives market and make our same investment with a better understanding of the risk involved. We would buy 1 call option with a strike at the money in AAPL that expire in June of 2019. Those call options allow us to participate in the upside (keep in mind we won’t get the dividend) at the same amount as our outright purchase above. The biggest difference is the cost of that participation. It cost $1620 for those options. We have limited the amount of capital at risk to the premium paid for those options.
The option allowed for reduced initial capital deployed and definitive risk in a security we wanted exposure to in the first place. We speak repeatedly on the importance of deploying investment systems that win bigger than they lose. The derivatives market can be an effective tool to facilitate that. It’s pretty simple, let winners run and avoid face ripping losses. Rinse and Repeat.