Wednesday, February 7, 2018

You Got No Business Buying Derivatives!

Never invest in something you don't understand!

I mentioned before that binary options are a sucker's bet. And the operative word is "bet" - you're gambling on an arbitrary indicia, the way particular stock price will jump up or down. That's not investing, that's gambling.

And I've mentioned before that you should never invest in things you don't understand.   Just because something is complicated, doesn't mean it's smart.  And if you don't understand it or it doesn't make any sense to you, it is not because you are stupid, but likely that someone is pulling the wool over your eyes.

Derivatives, as the name implies, are bets on what direction the price of a stock will go, and even how fast that change in direction will occur.   In Calculus, for example, the first derivative of distance x is velocity v, where v = dx/dt  - indicating the change of distance over time.   The second derivative of distance ddx/dt or the first derivative of velocity, dv/dt is acceleration.  And so on and so forth.   These derivative values show the rate of change of a variable over time.

And in finances, it is similar.   "Options" trading is basically betting on the change of the price of a commodity over time.  You either sell short (thinking prices will go down) or sell long (thinking prices will go up) .  You have the option to exercise these later on.  These are slightly different than futures trading, where a put or call obligates you to sell or buy the shares at a later date.  They are complicated financial instruments, but do have some legitimate uses in stabilizing markets and allowing people such as farmers and suppliers to "bank" profits ahead of actual sales.

What is scary, is that in researching this, I found a number of websites that cheerfully hawk "Options trading for beginners!" which is an horrific idea.   Like I said, you and I have no business doing this - you can lose a lot of money, as you are gambling on prices.  If you don't know what you are doing, you can lose not only your "bet" on prices, but a whole lot more money, particularly with futures, where you may be obligated to buy stocks down the road at a price many times their trading value (in reality, what you do is, give cash to the trader, based on the difference in the market price of the stock and the price you agreed to pay).

Like I said, it's complicated, and you have to be an expert in these things to understand them.   Most experts in this field are trading these derivatives with other peoples' money.    The most you can lose when you buy a stock is all the money you invested in it.   With futures, you can lose the contract money and a whole lot more.   On the flip side, if you "bet" right (and it is a bet) you can leverage yourself and make a whole lot more money.

For example, I bought AVIS stock in March of 2009 at 74 cents a share.  It went up 3000% within a year and I made a few thousand dollars.   Now suppose I knew this was going to happen in advance.   I could have invested everything I had on this bet and made a whole lot more - millions, in fact.   But suppose I could lock in a contract where I agree to pay, say, $1.50 a share for AVIS stock six months from then?   The cost of the contract itself was small, and when the stock went to $20 a share, I would be rolling in money - being able to contract to buy far more shares than I physically could afford at the time.   On the other hand, if the company went bust and the stock went to a penny a share, well, I would be on the hook for that bet.   It is risky, and yes, there are rewards, but again, you'd have to know in advance which way stock prices are going - and that is gambling, not investing.

In the recent turmoil in the stock market - a huge drop followed by a "dead cat bounce" - we've seen a new class of derivative crash and burn.   These "VIX" type notes are bets placed not on the price of a stock or even the DJIA or overall market, but the relative volatility of the market.   While options and futures might be like betting on velocity over distance, these "Volatility Index" bets are like betting on acceleration.   It is stock price abstracted by at least two levels, if not more.

And when the market became volatile, people lost their shirts.  Credit Suisse is closing down one such product, as its value has dropped to zero.   Others are apologizing to investors for the debacle.   The overall market went down a bit and recovered a bit - I gained a lot in January, lost the gain, and then gained some back.   The people who bet on the VIX lost everything.

And by "people" I don't mean Wall Street traders who are investing other people's money or hedge fund managers who get paid either way to invest Billionaire's billions.   Rather, a startling number of retail investors - chumps like you and me - placed bets on the VIX as if they knew what it meant and they could divine where it was going.   They were lured in by the promise of quick riches, just as the squirrels are lured in to my squirrel trap by the lure of sweet delicious corn.   But then the trap springs, and, well, so far six squirrels have found a new home on the causeway.   The hawks are very pleased.

Pigs get fat, hogs get slaughtered.   And many folks, hoping to make up for years of investing nothing at all, are putting relatively small sums of money into these "bets" - VIX notes, futures, Bitcoin, gold, whatever.   Or they are young people, hoping to "strike it rich!" by outwitting billions of other people, putting an options contract on a credit card - only to lose it all and now have a high-interest loan to pay off.

Either way, the net result is financial misery.   It is no better or worse than the Payday loan place or the check cashing store or the title pawn loan joint.   The only difference is, the folks selling these bad deals cloak them in the respectability of Wall Street and the stock market, and by calling them "investments" can get away with taking your money, whereas the same flim-flam perpetrated by a con artist would land him in jail.

Never invest in things you don't understand - if you do, you get what you deserve.   And no, you can't become an expert in derivatives, nor can you afford to gamble with the pitiful amount of money that passes through the hands of a typical middle-class person.