All Out: Why Asset Class Names Can Be Misleading
This edition is a bit late; I was going to write about another topic, but I’ve had some discussions over the last couple of weeks that I wanted to talk about. I’ve heard from several people that they don’t invest in products which have derivatives because they are “too risky”. Honestly, without knowing more about the products, making conclusions like this is naïve and shows a lack of understanding of basic finance.
We’ll get back to the derivatives later on, but first we want to start off with a simple asset class to illustrate a concept. The concept is that many times an asset class’ name can be misleading. Let’s start with a simple example which we’re all familiar with, debt. Debt is simply a contract between two (or more) parties to lend and borrow money. The money has to be paid back at a certain date and the borrowing party has to make interest payments as compensation to the lender. A debt contract can be as simple as you give me money, I’ll pay it back in one year and pay you 5% extra (interest) as compensation for the money you lent me. Most people would say that debt is a “safe” asset and should be the ballast in your portfolio. In general, debt is senior to equity, so the theory goes that it is safer than equity. And this is mostly true if you focus within one single entity. For example, Apple’s bonds are safer than its equity because in a case of bankruptcy the bonds will get paid back first before the equity holders receive anything. However, you could argue that Apple’s equity is safer than the bonds of Tupperware (which is close to filing for bankruptcy). But even just focusing on bonds, the devil is in the details.
Debt is a huge asset class and can encompass anything from short term Treasury bills, to structured products (technically a structured product is a debt instrument that the bank sells you), all the way up to complex debt instruments like CDOs (which blew up in the financial crisis). These different kind of debt instruments have very (VERY) different risk profiles. Treasury bills are the safest investment you can own, essentially risk free both from a credit and interest rate perspective. So, if I tell you, I have a 100% debt portfolio you have no idea how risky my portfolio is. I could have 100% Treasury bills in which case it would be a very safe investment. Or I could have a portfolio of Argentinian government 100-year bonds. In case you don’t know, Argentina issued a 100-year bond in 2017 at an interest rate of 7.125% (who bought this bond from a country which had just gotten out of their 11th default in 2014 is beyond us). Anyways, this bond traded between $70-80 until August 2019 which it dropped in a couple of days by 50%. It then went on to drop to a low price of $24.85 during Covid. So yes, this is a bond, but it is nowhere near safe or low risk. It was filled with credit risk (from a serial defaulter), and interest rate risk since it had a maturity in 2117 (it defaulted a couple of years back).
So now going back to derivatives. A derivative is a financial contract whose value is derived from another asset (hence the name derivative). An option is the type of derivative that we want to focus on, but the concept is applicable to other type of derivatives. Many people have preconceived notions that derivatives are risky. However, derivatives were first invented as a way to lay off risk. The first futures contracts were for agricultural commodities so that producers could hedge their price risk. If I have an orange farm and want to lock in my price today, I can sell forward the oranges. So essentially we can agree on a future price today and I’ll deliver the oranges when they’re ready to be delivered. So, selling them forward is a mechanism by which we can lock the price today but deliver the goods in the future. This way if the price of oranges rises or falls, I won’t be impacted because we have already established a price. This is the most basic for of hedging, taking out price uncertainty.
Going back to options, many people assume that they’re risky just because they may have heard something bad about options. Sure, options can be very risky if not used properly. But with appropriate position sizing and risk management, investing in options can be tailored to different risk levels. The same way we can have a bond portfolio that barely moves (Treasuries) or a bond portfolio that drops 60% (Argentinian bonds).
This is probably best highlighted by an example (not investment advice!). Let’s say that I have $1M and I think the market will go up over the next month, but I want to express my trade using options. There are many trades you could structure that would pay off if markets went up. But let’s say I wanted a simple trade, so I just bought calls (a call goes up in value as markets go up). To make things simple, let’s say I just bought a 4480 call (at the money, i.e., the S&P 500 right now is at 4480) for $78.50, the total cost would be $7,850 (each contract represents 100 times the index). So, my maximum loss on this trade is fixed at $7,850. If the S&P 500 drops to zero I will only lose $7,850 on this trade. What’s my maximum profit? In theory infinity. Realistically though the trade would be profitable if the S&P 500 returned anything above 1.75% (the cost of the option, 78.50 / 4480). For example, if the S&P 500 was up 5% to 4704, I would make $22,400 for a net profit of $14,550 (4,704 – 4480) * 100 – $7,850 = $14,550.
So how can this trade be low risk vs. high risk? Well, it all comes down to sizing, i.e., how much money you place on the trade. If you just buy 1 contract, then it’s a fairly low risk trade. The most you could lose is $7,850 and that in a $1M portfolio is just 0.785%. However, this could be extremely high risk if you bought 127 contracts, for a total of $996,950. Sure, you could make a lot of money; if the S&P is up 5% this trade would gross $2,844,800 for a net profit of $1,847,850. But if the S&P is flat or down any amount you would get wiped out. So exact same trade, but with very different risk profiles. It essentially goes from a maximum possible loss of 0.785% to essentially being wiped out at a loss of 99.6%. The only difference in the trade is how much money you put into it. This is a clear example of how options can be high or low risk depending on how you use them.
This same concept even applies to the safest asset, Treasuries. There are trades that are low risk trades (such as on/off the run arbitrage, of futures-cash basis trade) which some funds put on with tons of leverage which can be catastrophic. In fact one of the culprits of the LTCM implosion was the on/off the run arbitrage trade; which in normal markets would be very stable, but they had the trade on with a lot of leverage and it moved against them. This and many other leveraged trades led to their blowup.
This post may have been a bit in the weeds but I’m getting a bit annoyed at people saying that something is “risky” just because it uses derivatives. Most investments can be risky if you don’t know how to use them. And many “risky” investments can be just fine if you size them right and know their role in a portfolio. So, when you hear somebody tell you, oh this is a safe investment because it only has debt, or this is risky because it only uses derivatives, then ask them to explain themselves to see if they really know what they’re talking about or if it’s just a cop out answer. Like I think you may have gleaned from reading this newsletter, finance is pretty complicated and rarely are things black and white, rather they are most often different shades of grey.
