Options – Futures With Insurance

Inflation Protection

As discussed earlier, on the world’s financial markets the dominant theme of the second half of 2010 has been an increasingly broad-based devaluation of the USD and its fellow paper currencies.  Sugar, wheat, coffee, copper, silver, lead, corn, tin – you name it – precious metals, fuel and food are all up by 40% or more against paper. Of course gold has risen, too – though in today’s supercharged inflationary environment the least of all commodities.

Simply put, this is inflation, at least in paper terms. In terms of silver, prices of commodities are roughly stable, and in terms of gold they are rising slowly. Prices for real estate by contrast, though in many places stable in paper terms, are falling dramatically in terms of commodities.

With annual price rises for basic goods approaching 100% in paper terms, people holding their wealth in paper and paper-linked forms (such as outstanding debt and real estate) are facing a potential 50% annual haircut. While one could certainly argue that at least 50% of current “assets” were fictitious in the first place, those watching the markets have the opportunity to cut short the barber shop visit – or perhaps even get in on some of the clipping business.

If selling off our houses and collecting all our debts overnight were easy, I suppose we could all simply load up on silver and wait the storm out. However, life must go on, and in most cases that’s simply not too feasible. So what can a wary person do to minimize the impact of the devaluation – or even turn it to one’s advantage?

The Perils of Futures

Buying futures or their equivalent has long been the standard answer to this question. In essence, this is buying on margin. You put up 1-10% of the total principal and for hedging or speculative purposes get exposure to the whole. Such services are offered through many brokers, online trading platforms and (for gold and silver) even through a few forex trading platforms. And no doubt this approach CAN work – if you are VERY disciplined and never draw on more than a small fraction of your reserves.

For the rest of us, however, futures can be quite perilous, a fact many have discovered too late.  Markets, even those in a trend, seldom ascend or descend in a straight line. Even if the trend holds, major corrections of 20%, 30% or even 50% can and do occur, and in time these dips will tend to wipe out most market dabblers. Whether this is some natural phenomenon or a nasty trick played by the PTB is hardly relevant; it is simply a fact of life.

Psychology of Margin Trading

The basic principles of successful trading have remained the same over the ages: buy low, sell high. The time to buy is when markets fall. For those using margin to hold long positions, however, this principle is difficult to implement. Why? Simple – those holding open long positions are psychologically motivated to do the exact opposite of what they should be doing. When markets fall dramatically, they worry about getting wiped out and often reduce their holdings. Given the real possibility of being wiped out, in its own way this is perfectly logical. Yet at the same time, not only does it does not strengthen one’s financial hand, it contributes to a lot of restless nights.

A Better Way

Luckily there is an easier way, particularly in fast moving markets like those we are experiencing today: options.

Many commentators have pointed out that most options expire worthless; hence the attraction of writing them. This may well be true. It is also true that options are invariably more expensive than futures: a premium must be paid above and beyond the intrinsic value of an option at a given price. And yet, this does not mean that they do not have their value.

Premiums are the cost of buying options, consisting of two parts: an intrinsic and a time value. The intrinsic value of an option would be its value if exercised on the spot. The time value is the rest. Since the intrinsic value is actually no premium at all, the real premium is the time value of the option, the additional price over and above its intrinsic value. This is what the smart investor must watch.

Don’t Buy High

Where are the real premiums the highest?

They are highest exactly at the money – where most investors buy them. At the money means that the exercise price equals the current (or “spot”) price. Options at this level have high premiums, but no intrinsic value.

Buy Low

In an options market, it’s almost always possible to buy low. Just look where the premiums are lowest. They are usually low either at exercise prices which are significantly in the money (say, at least 5-10%), or at exercise prices far out of the money (say, at least 10% above the spot price).

What do I get for the premium on a call option? I essentially get insurance against a fall in the value of the commodity bought. If the price of that commodity falls by 20% and then recovers, I cannot get wiped out, as I can with futures. If I have kept reserves, I can buy more at a 20% lower price. And, if the 20% sell-off takes place within a relatively short period of time, the increased time value of my options partially compensates for the loss in intrinsic value.

Those are some pretty substantial advantages.

So I want the insurance, but at a low price. In that light, the secret is obvious: Buy options with low real premiums. In most markets, expensive 9-month options 15% in the money sell for tiny real premiums. The same is true of options 10-15% out of the money. In the first case, almost the entire cost of such options reflects their intrinsic value. This means that you are essentially buying the commodity outright, but without having to pay for more than approximately 20%. In the second case you are getting exposure to a particular commodity without paying a lot for it. And in both cases, you cannot be wiped out on temporary dips.

Costs & Advantages of Insurance

If you only paid a low premium and prices are down 15% when the option expires (thus rendering it worthless), you simply buy another at an exercise price 15% farther down. Your cost to do this is only marginally higher than if you had bought a future or the commodity outright in the first place – and this is the worst case scenario. If the market price is down 25% when the option expires, your insurance policy probably saved you at least 8%. If the market is only down 10%, so you lost your tiny premium. Buy again and keep waiting for the market to turn. As long as you are right about the long term trend – and have sufficient patience – you cannot fail to eventually win.

Futures with insurance.

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One Response to Options – Futures With Insurance

  1. Pingback: USD Devaluation Picks Up Speed | Aha Moments

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