What are Derivatives Really?

Billion derivative contracts are being traded yearly and most companies and investors use derivatives to lower risk. – So, what are Derivatives and should you invest in them?

Jeff Powell, CIO, Managing Partner & Founder of Polaris Wealth & Jeremy Witbeck, Partner at Polaris discuss how financial derivatives work, are used and whether you should consider using adding financial derivarives to your financial  portfolio.

 

Jeff Powell

Jeff Powell

Jeremy Witbeck

Jeremy Witbeck

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Jeremy Witbeck:
Welcome to the Polaris Podcast. I’m Jeremy Witveck, a partner at the Polaris Wealth Advisory Group. And with me today I have our chief investment officer and managing partner Jeff Powell, Jeff, great to see you. 

Jeff Powell:
Good to be here. 

Jeremy Witbeck:
So Jeff, I’m looking forward to our conversation today. This is one that I think, in some respects is a little bit mystified in the way that we talked about it in financial literature, because it’s not something that necessarily a lot of us have ever dabbled with directly. But I’m hoping that with the conversation with you today that we can kind of take away some of the the misconceptions, or just the lack of understanding with a instruments that are called derivatives. So if you don’t mind, Jeff, can you give us just a brief explanation? What is the derivative?

Jeff Powell:
Well, it’s kind of funny, because as you said, Jeremy, there are a lot of misconceptions about derivatives about risk and derivatives. A derivative is simply a product that has derived from something else. So for example, and I know they’re going to talk about this in a few minutes, but like, derivatives can be very risk free, as zero coupon Treasury, for example, or Treasury strips are derivatives of a regular treasury bill, or a bond or note or whatever, but, but they are derived from an original product. So when somebody says, a derivative, you know, as much as it might have, and certainly has been dragged through the mud at different points in time in the financial industry, but a derivative is is nothing more than just a, a offsuit product of original product.

Jeremy Witbeck:
Gotcha. And before we get into specifics as to certain types of derivatives, what is the purpose of the derivative? Why would someone potentially use that within their portfolio? Well,

Jeff Powell:
I mean, different derivatives have different purposes. I mean, for example, gamma, we’re just talking about treasuries. So there is, I think, on a treasury strip, a treasury strip is just all the income from a treasury. So when you hear about clipping coupons, people oftentimes think that that’s like, Okay, I’m going to the Sunday newspaper from days past, and finding all the coupons in there, I’m going to clip them out. And I’m going to bring them to the store and spend them that’s not what coping coupons was originally, that statement is originally from bonds, bonds, if you bought a bonds, and it was an end certificate form, on the outside of the bond, there would actually be coupons, no coupon is a form of payment for a loan. And so you know, when you talk about yields, and everything, also bonds, that’s all derived from how much money you’re going to get paid. So what what ends up happening is people would cut a coupon, send it in, and then we get cash back from sending in that coupon, or that bonds. So somebody’s got the idea of saying, Okay, well, what if we took all the coupons off, and we get, we basically sold the income of this to one person, and then somebody else bought, just the appreciation, because if you don’t have any income, you’ve got to discount that investment in order to do that. So so for one person, they might want the growth pattern of a bond, the other person might want the income of a bond. So Wall Street came up with the idea of separating those two things. And so in this case, you know, again, with the the whole idea behind it, as one person wants very little movement in price, and they’re going to just take the income and the other person wants growth. So that’s, that’s one way of being able to do it. Other derivatives, you know, what you’re really doing with options and futures and, and things of that nature, which are other types of, of derivatives, as you’re basically trying to lock in a future price of an investment that you’re making. And that can be sold that can be bought, you can be on both sides of it, depending on the length of time. But basically, you’re saying with a with a future, which is, when you hear about what happened last year, for example, with oil, you’re basically saying, I’m taking delivery of barrels of oil at a specific time, and a specific price in the future. And that’s why they’re called futures is that you’re buying them in the future or selling them in the future you might have, if you’re actually an oil company, and you want to lock in a price for your oil that you’re taking out of the ground, I can sell you the right to buy my oil at a specific price at a specific time. And so it’s a way for companies to walk and things. You can also play with currency the same way. So if I’m doing a lot of business, let’s say in Japan, and I’m an American, and I don’t want to take a currency risk, I can actually use futures to actually hedge the risk that I’m taking of having that All our devaluate against the end, for example, if that were to happen, so there’s a lot of different tools that futures play, and they’re not out there. I mean, if you’re speculating on anything, it doesn’t matter if you’re talking about options or futures or anything else, you know, again, if you’re speculating, you’re gambling, it’s just that oftentimes with these types of things, because they’re leveraged and a lot of ways, then they’re your mistakes tend to be bigger, and your gains tend to be bigger also. So you get people that are speculating more within that base, which is, I think, is really why they have the the negative connotation that they do.

Jeremy Witbeck:
Yeah, no, absolutely. And you hit on a great point there that derivatives are oftentimes used for hedging purposes, or making your portfolio less risky. Or, of course, you can use it for speculative purposes and make the portfolio more risky. And I think Unfortunately, the media often covers derivatives in the light of the speculative side, that’s certainly the more glamorous or sexy side, if you will. But I think what’s forgotten is the other half of the equation, though, is that it can be one of the most powerful and effective hedges out there for different instruments, and certainly serves a great, great place in the marketplace to do that. And then the other thing that I really liked your example of your strips, and zero coupon treasuries as an example, right, the derivatives markets really injected a lot of liquidity and opened up participants that otherwise would not be attracted to certain type of instruments. So for example, if I’m a project manager, and I have a project due in two years, I don’t want the income, I just want my value in two years. So I can start the project, right, a zero coupon bond becomes very attractive to me. And so using stripping off the income, giving it to someone else, and just give me a zero coupon means now I’m a willing buyer of that bond, whereas I would I may not have been earlier. And so that brings greater efficiency to the market, which hopefully also improves returns on prices for participants. So I would say a lot of goods come out of the derivatives market when they’re used correctly. Um, Jeff, do you mind if we go through a few more common examples and just kind of explain what they are and how they work with our audience today?

Jeff Powell:
Of course.

Jeff Powell:
So I think the place to start off with are the two more common that are talked about, and that is a call and put options. And so just what is a call option?

Jeff Powell:
Well, it’s the ability to buy a particular investment at a particular time in the future. So you basically, what you’re hoping for out of that circumstance is to lock in a price. So let’s say that there was a stock that was a $50 stock, and I wanted to speculate upon this, and I thought that that stock was not gonna be at $50, I was gonna be at $70 in two months time. So right now we’re at the end of February. So I go out and I buy the 50 calls on XYZ company, but I’m going to buy them with a maturity date that’s out at the end of April, for example, if that stock goes up, and up and up to 70, I now have the right because I purchased these calls to purchase the stock at 50. From the person that would that sold me those options. So I’ve automatically got a gain that’s built into that. So I may have paid a price. So with an options, there’s a thing called time premium. So that is the built in two month time period, that I that I was paying for.

Jeff Powell:
Again, the time premium will oftentimes vary based upon how volatile the stock is, or what is referred to as delta. So the more volatile stock is, typically the higher the time premium will will be that instrument, because it’s much more difficult to predict where it will be in the future. I can also sell the right to to have somebody else so you can be a buyer or seller of a call. So if I think you know, I already own XYZ, and I’m comfortable with selling the stock at $60 a share, for example, and it’s sitting at 50, I can sit there and sell that to you, let’s say for $1 because it’s out of the money, meaning that the stocks at 50, I’m selling you the right to buy it at 60. So that’s an out of the money call. Because it’s $10 out above where the price was. But I’m giving you the right that if it does go to 70 or 80 or 90, you can buy it at 60. So you’re you’re betting that the stock will go up, I’m betting the stock is going to stay between 50 and $60 a share and I’m going to collect that dollar premium. So automatically right now, if the stock does nothing, it stays at 50 for the next year. I’ve just picked up a dollars worth of income. And then you know two months from now if it’s still below 60. And I want to try to do that again. I can sell for another dollar or something similar to that. So writing covered calls that’s covered meaning that I already own. The underlying investment is actually a fairly risk free way of being able to play the options marketplace. Now you do limit your upside, and that situation and so the the investor should be aware that, hey, if the stock rages, it goes up to 70 or 80, you got to be comfortable with where you sold it, I sold it at 60. And I can’t begrudge the fact that it’s gone up more than that, what you really have to be looking at is saying, okay, I took an educated guess at where this thing might go over a short period of time, I collected the income on it. So I’m willing to get out of that stock at $61, because I got a 60 price, and I got the dollar from the option. So again, written cover calls. Now a put is the exact opposite. You know, you’re basically protecting the downside. So if I bought a put on the same store, for example, I bought a 50. Put, really, what I’m expecting is the stock to go down. And I can sell it back to the person in the future at $50. So if I own or let’s just say I bought the the option on XYZ, to put the stock back to you at 50. And it drops to 35. You know, I make the difference between the 35 and the 50. Because I’m selling to you at 50, I’m buying it back at 730 $5. So I’ve picked up that money, I can also sell that option. So again, on calls and on puts you can be a buyer of or a seller of and basically what you’re doing is either trying to protect to the downside, or speculate to the upside. Now one thing to add to though this Jeremy, which is we’ve been talking a lot about is where you know what’s not risk less but hedging and protecting. So written covered call is a great idea for a lot of investors that have a concentrated position. So is buying puts a time. So let’s say you own the XYZ stock, and it’s coming into earnings season. And you’re kind of concerned what might happen with that company, but you’re not really willing to sell it yet. So what you might want to do is buy, I don’t know 45 plots or 40 plots, and basically buy yourself some insurance that says, hey, if the stock goes below $45 a share, I’m making back $1 per share in a situation. So I bought insurance so to speak. So you’re playing a way of being able to protect your portfolio in a way. And then the last of it is what’s called a color. Now, a color you got to be very careful with because there are IRS implications. If you if you have a color that’s too close together, basically, the IRS calls that a constructive sale, and will charge you as if you sold the stock even though you didn’t. So you really need to be working with an advisor, when it comes to a lot of this stuff. But what you imagine if you said okay, I’m not really sure which direction the stock is going, you know, if you if you know point blank that your underlying stock is going to go up, keep it if you know it’s going to go down, why buy the insurance on it, why take that 50 to 45 price, just get rid of it sell it, you might be able to pick it up at a later price. But if you’re not sure, that’s where a lot of times options come into play. And so it’s the common thing with regard to a stock that you have a highly appreciated value in is to sell a call. And with that money that you get from selling the call, you buy a put. And so these become basically, it’s called a zero cost color. So you’re actually using the proceeds from selling the right to buy the stock and the future price above it. So let’s make the math simple here is $100 stock, I might sell 110 call in order to pay for a 90 put. Now, it doesn’t always work that way, again, with time premiums and so on. Typically, you’re going to have to give up a little bit of that upside. So it’ll be more like 108 call and a 92. PUD or I’m sorry, a Ada plus. So you’re getting a little bit more downside, and not getting quite as much upside on it. But basically what you’re doing there is saying, Hey, I’m okay with this stock price ranging in here, oftentimes that’s used with companies that have higher dividends or something else along those lines. So you can sit there and get the income from it, and not really have to worry that you’re going to lose a lot of value on the downside. So it’s a way for you to be able to actually pay for that insurance by limiting your upside. So a lot of different the same options, but a lot of different things that you can do in order to mitigate risk. We’re not talking about eliminating risk. When we use the word mitigate. We’re talking about lowering our risk, but there’s lots of ways to be able to use these option contracts in order for it to actually benefit the client in the end, while taking less risk.

Jeremy Witbeck:
Yeah, Jeff, that was a great and very thorough explanation. And that’s the part that I think is very misunderstood is that with options you can use it to trade away and unknown and lock in a noun. So for the example the call right, you’re trading away unknown upside and in return you’re getting enough cashflow or known income from the option. And the puts the same thing you’re trading a known expense buying that put and trading away and unknown potential future loss. And I think when when understood in that context, there’s a lot, there are very powerful tools that you can use in combination, and you hit on a few of the more powerful ones like a color, there’s certainly vertical spreads and other things. And so a lot of a lot of additional tools that we have in our in our arsenal that can help clients achieve their goals, especially when you’re dealing with concentrated portfolios, as you alluded to earlier, so recognize that not everyone can just sell out of a concentrated portfolio, you may have deep embedded gains may not be the right tax year, and so forth. And so there are other ways to hedge that risk to your point to accomplish the goal and to spread things out to where it makes more sense from,

15:48
we could spend an hour on on this, or more just going through different strategies, you know, straddles and iron condors and butterflies and all sorts of other things. I mean, this is this is options. 101 some very, very simple examples of where options are, you know, again, that’s your point, you know, taking a removing unknowns, and putting a much more powerful situation. And our clients and so you’re 100% correct with that, Jeremy?

Jeremy Witbeck:
Yeah. And, Jeff you you touched on a little bit earlier forwards and futures, more specifically futures, and certainly had a lot more talking points in the media recently. And we went through the recent event with oil futures going down into the negatives, and I think this is a good example, to really kind of lock in how futures contracts work. Specifically, can you walk us through? Why did oil futures go negative? Why were people actually paying people to take their futures contracts on a valuable commodity like oil? Because on the surface, it doesn’t make a lot of sense?

16:53
Well, yeah, I mean, so let’s, let’s go back and just talk about what the future is. I mean, I am, if I am a buyer of oil futures, I’m saying that I’m willing to purchase a barrel of oil at a specific price in the future. And when that contract comes up, there’s physical delivery of this. So when you hear about wheat futures, or L of or oj or frozen orange juice, and all this other stuff, I mean, they’re physically delivering us. So where do you want to take in a bushel of wheat? Do you want to take in, you know, barrels of oil. So what ended up happening with the oil market last year is we had, you know, a kind of a perfect storm, we had already had a huge amount of surplus on hand, which is why oil has been going down in value for quite a while, obviously, with the pandemic coming. And people were using less fossil fuels. So the amount of oil and people were still pumping it at the same rate, with the use rate was going down dramatically. And then it got to a point where literally, storage facilities were absolutely full. And so when it came to actually the end of the future contract, nobody had a place to put it. And so yes, people were joking, gosh, I could have bought oil, somebody could have paid me $40 a barrel, to jail for oil. And I can just sort of back and I could have made a bundle on it. But yeah, but where are we going to put it? You know, I don’t know about you. But uh, you know, a, I don’t have a swimming pool. So I can’t put it in there be I don’t know what my wife would say if all of a sudden, there were a couple 1000 barrels of oil sitting in our backyard, let alone My neighbors. So you physically would have had to take delivery of that oil, and then figuring out how you’re going to sell it afterwards. And and again, selling it in the in the futures market and then delivering it to somebody afterwards. So it’s not as simple as just saying, you know, you’re you’re buying and selling on the date that these futures come. And that’s where the price fluctuation was all over the place. And we’re literally I mean, I remember being on the phone talking with, with my analysts, literally watching it going, you know, down and down and down and being like, Oh my gosh, it’s now down below $20 a barrel. Now it’s down below 10 an ounce. Now, it’s basically a two I mean, and then I went negative and you’re just like, Oh, my God, I cannot believe this is actually happening. Well, yeah, it really happens. And it happened for a reason. And again, probably not something that we see again in our lifetime, because of the kind of the perfect storm of what we saw. But that’s why there’s fluctuation. Again, it’s a supply demand thing. It is, you know, again, a commodity. And it’s only worth what somebody else is willing to pay for it. So that’s the reason why it went negative.

Jeremy Witbeck:
Yeah, so it was really interesting to see like the Jeff had never seen anything like it probably once in a lifetime. But it just goes to show that behind all of these derivative instruments, so there’s an actual commodity or an actual stock or an actual underlying security that’s tied And so it’s important to keep that in mind when you think about these different instruments. Because at the end of the day, that’s, that’s what they’re, they’re priced upon. That’s what they’re controlling. And that’s what you’re investing in when you use them. So as always, Jeff, really appreciate your expertise and insights and your explanations were were great. I really enjoyed the way that you broke these down and helped to demystify some of these subjects that sometimes seem a little bit more confusing and complex and what they really are. So thank you so much, my pleasure. So and to everyone listening with us thank you for for listening, and as always be happy, be safe and be healthy.

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