Using derivatives during market crash

[Damien]

Hi guys,

is it viable to use options to buy beaten-down stocks during a crash, increasing possible profits from the recovery?

Have anyone thought of it? Was thinking if it is possible to buy call options maybe on US market since SG warrants are limited.

[vesfreq]

Hi guys,

is it viable to use options to buy beaten-down stocks during a crash, increasing possible profits from the recovery?

Have anyone thought of it? Was thinking if it is possible to buy call options maybe on US market since SG warrants are limited.

Ermm.... overseas stocks have an additional fx risk. Options have a limited lifespan. Why not refinance the house and use the proceeds to buy? At least, stocks have no "limited lifespan", unless company go bust.

[Damien]

Refinance the house you mean by selling it or down grading? yeah, options have time span, but judging by the last crash, I think that crash and recovery took 2 years? of course, no one really knows how long they will last.

Maybe can consider some money in options to increase total returns...

[tanjm]

Using options is just basically using leverage. You outlay 5% of the cost of the shares (for example) and hope you can call (buy) the shares cheaper than the market in (say) 3months time. Using a margin account is also leverage (but where you trade off unlimited downside against having to pay interest on your margin and a unlimited time to expiry).

There is no free lunch. In a derivative contract, you need a willing counterparty who thinks he has a reasonable chance of making money off you - in other words, a zero sum game. For a retail investor, it is likely a negative sum game given transaction costs plus the fact that the other counterparty is most likely a more skilled market participant than you. The premium on the option will be priced accordingly to the likelihood of being in the money.

Let's have a concrete example.

Say the market has gone down. You enter the market looking for an option contract. You cannot find any cheap long dated ones (likely) and you settle for a 3M expiry contract costing 10% of the per share cost. In 3M, the options expire out of the money, and you are out of pocket 10%. You repeat again, paying another 10%. In perhaps 9M, you pay 30% in total for 3 rolled contracts. Finally! this time you are in the money, get to call the shares and make 15% profit : you have lost 15% over 9M.

If your counterparty thinks that the market is very likely to rise to the strike you want in the time of the option, you will either not be able to find a willing counterparty or the premium will be very high. "No free lunch".

Basically, for a uninformed investor, buying an option is similar to buying a lottery ticket. With a lottery ticket, you too pay a small amount for a large potential gain and you have no downside other than the lottery ticket price. But you could end up spending a lot of money on lottery tickets :-).

[Damien]

Yup, agree with your example. But what if the contract is for 2 - 5 yrs? Not sure if there is, have to go check it out. I haven't logged into my optionsxpress account for a long time. And also assuming that there is a second party that wrote that option, not sure if anyone has done it before, definitely heard of people using warrants after the market crashed.

Yeah the difference between options and margin is that options have a limited loss if you do not exercise. For margins, you stand to lose the full share value? Just a friendly discussion on the various options that may increase our value investing returns lol

[weijian]

Yup, agree with your example. But what if the contract is for 2 - 5 yrs? Not sure if there is, have to go check it out. I haven't logged into my optionsxpress account for a long time. And also assuming that there is a second party that wrote that option, not sure if anyone has done it before, definitely heard of people using warrants after the market crashed.

Yeah the difference between options and margin is that options have a limited loss if you do not exercise. For margins, you stand to lose the full share value? Just a friendly discussion on the various options that may increase our value investing returns lol

The longer the contract duration, the greater will be the premiums then. Generally, the more 'sensible' strategy for value investors would be to buy deep out-of-money put options during the bull market to act as insurance.

Forumer vesfreq's mention of 'refinance' simply means to mortgage your house - If your house is worthed 1mil on the market and you have a 0.2mil loan left, you can get 0.6mil cash if you refinance it with 0.8mil loan (assuming the bank allows you 80% loan to value). The end result is that you end up with 0.6mil cash on hand, a 0.8mil loan with more interest to service per month and still a house to live in.

There is really only one way for us to increase our value investing returns - that is to continue to work hard to improve our circle of competence and understand the boundaries of our circle of competence. That said, i will also recommend a few tips that i found useful in the last crisis that may potentially improve a value investor's return:

(1) Stop reading newspapers/call your broker/log into your internet trading account.
(2) Maintain my sanity by continuing to enjoy time with friends/family and exercise alot to have a 'clear line of sight'
(3) An elephant gun that is loaded (hem...well, doesn't have to be Buffett's type and size)
(4) Stay employed
(5) Use your own mood as the buy signal - I suspect it should be the perfect contrarian indicator

[tanjm]

Yup, agree with your example. But what if the contract is for 2 - 5 yrs?

It doesn't sound like you understood my main point or perhaps I am a bad writer. It is a zero sum game. If you can even find someone willing to offer a long dated contract, the other guy will charge you an arm and a leg for the privilege. And even then, you can't even be sure of being in the money sufficiently to break even.

I say again "there is no free lunch".

[Damien]

In the first para you were comparing options with margins, which are not the same. As you mentioned in your second reply, you mentioned higher premiums when the writer thinks that the stock will be higher within the period of the option. Yes, in that case I agree with you that the cost of the option may outweigh the benefits that it may provide.

I am considered new to the market and have not yet experienced a crisis. But I am sure that there will be one in coming years and preparing myself for it; hence the consideration of this topic. But about having no free lunch in this world, its very subjective.

thanks weijian & tanjm for your helpful opinions, appreciate it!

[vesfreq]

In the first para you were comparing options with margins, which are not the same. As you mentioned in your second reply, you mentioned higher premiums when the writer thinks that the stock will be higher within the period of the option. Yes, in that case I agree with you that the cost of the option may outweigh the benefits that it may provide.

I am considered new to the market and have not yet experienced a crisis. But I am sure that there will be one in coming years and preparing myself for it; hence the consideration of this topic. But about having no free lunch in this world, its very subjective.

thanks weijian & tanjm for your helpful opinions, appreciate it!

The guys gave pretty spot on advice on the use of options. I wouldn't touch options, for the fact that it has a limited life span and it increases the already high degree of uncertainty in equity investments.

For your purpose, margin may be workable, but will not give the kind of leverage like an option. Suppose it also depends on the brokerage.

[CityFarmer]

In my conservative view, derivative should only be used to hedge risk, i.e. a supplementary investment tool. It should never be used as primary investment tool alone for PnL.

For e.g. if you are long-short investor, a option is useful to hedge against your short.

(from a conservative investor)