Derivatives: Options - Conclusion (4)
While derivatives are interesting to use, it can be like fire in the hands of a child when a novice investor who does not understand the intricacies involved decides to make use of it. It is a very quick way to make some quick bucks in a short time and also a quicker way to lose a lot of money within the same time frame.
The returns attributable to options are not uniform like that of stocks and bonds. It is quit difficult to get the true risks associated with these strategies. The measured risks in the form of standard deviation may be falsely low when the returns are skewed either positively or negatively and outliers have not occurred as is normal using these strategies. What this means is that people who use options may claim to have superior returns as often seen when they make a lot of small positive returns that may be wiped out by a single large negative return. Others may claim less than average returns that are usually small and in large numbers that may also be offset by one large positive return.
Options are not restricted to stocks and bonds. They are also used extensively to hedge risks associated with foreign currency, commodities, interest rates, portfolio of stocks and bonds, and anything else that has a random return.
In the use of options with stocks as highlighted earlier, it should be noted that the call writer who will have to sell the stock does not need to have it in their portfolio. If the option is exercised, the writer will have to go to the market to purchase the stock, which they will sell to the call buyer at the agreed exercise price. In the case of a put, the put buyer does not need to hold the stock in their portfolio and they can always purchase the stock from the market and sell to the put writer at the predetermined exercise price.
There are several ways of terminating derivatives; they can be terminated at the end of the expiry date either by exchanging cash for the underlying asset or by the loser of the contract paying the cash equivalent of the contract. They can also be terminated by entering an opposite contract with another investor or with the same investor.
Derivatives are very complex and options are priced by using a combination of stocks and bonds in such a way as to reach prices that are free of arbitrage advantages. They should be used with caution.