Derivatives & Options

What a derivative actually is and how it's structured, how returns and losses are made, how options are priced, evaluating a specific position, its risks, costs and taxes, and where it fits, if anywhere, in a portfolio.

Contracts whose value comes from something else

Lessons

• A contract about a price, not a piece of anything — An option or future is an agreement whose value depends on another asset. You own a right or an obligation with an expiry date, not a share of a business. (10 min)
• Big percentages on a small bet, and most bets expire worthless — Option payoffs are lopsided: a bought option can multiply its premium or lose all of it, and the price usually has to move a long way just to break even. (12 min)
• You pay for intrinsic value, time and uncertainty - and time runs out — An option's price has two parts: what it would be worth if exercised now, and extra value for the time and volatility left. That second part shrinks to zero by expiry. (12 min)
• Appraising one position: maximum loss, break-even, cost and what you are really betting on — Before any derivatives trade, write down five numbers. If you cannot fill them in, you are not evaluating a position - you are guessing. (11 min)
• Unlimited loss on the short side, spreads on every trade, and tax rules that vary by contract — Derivatives add risks shares do not have - assignment, margin calls, unlimited short losses - plus higher trading costs and tax treatment that differs by product and country. (13 min)
• For most readers, nowhere - and the exceptions are narrow — Derivatives can hedge specific risks or adjust a portfolio at a known cost, but they are not needed to invest well, and for most people the right allocation is zero. (8 min)

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