Introduction to Derivatives - Part 2
Application of Derivatives in Investing
Disclaimer: If you are going to trade derivatives, be careful. Start small and learn. Always do your own research before investing. Not investment advice.
If there is interest in a deeper dive on a particular type of derivative, comment below or DM me on Twitter (@BowTiedWombat)
Introduction
This is the second post in the Introduction to Derivatives series and will specifically discuss how institutional investors use derivatives. The first post (link) introduces the various types of derivatives, their classifications, and gives brief examples.
The way in which derivatives are used may or may not be familiar (or of interest) to you, so I have included a table of contents below to help you navigate the topics covered in this post. Note, this list is not comprehensive.
How do institutional investors use derivatives?
Leverage
Operational Efficiency
Less Trading
Manage Liquidity
Ease of Access
Risk management
Return Enhancement
Options for Directional Bets
Hedging
Rebalancing
Overlaying cash flows
Options based rebalancing
Leverage
Leverage - a financial position in which one takes on more market exposure than they have cash in order to amplify returns. It can be achieved through borrowing cash or by using derivatives.
Most people understand the concept of leverage as it applies to borrowing cash, but leverage in the context of derivatives can be confusing. The most important concept to understand is the difference between cash and notional value.
Cash value - dollar value of physical securities and/or cash
Notional value - dollar value of exposure to the underlying security
For most derivative contracts, notional is a stated number. Futures have a twist, in that they use a multiplier to scale the contract. Let’s look at the idea of notional as it applies to futures (I will end with a quick note about how notional applies to and is different with options).
Notional = # of contracts x contract price x multiplier
Example: You buy 5 ES (S&P500 E-mini) contracts at $4,000 with a 50 multiplier. This translates to $1 million of notional exposure (5 contracts x 4,000 price x 50 multiplier).
To show how using derivatives for leverage works, let’s walk through 3 different positions:
Cash position
A fully collateralized derivatives position (i.e., hold $1 of collateral for every $1 of notional exposure)
A leveraged position that is 50% collateralized (i.e., hold $0.50 of collateral for every $1 of notional exposure)
Assume the following for all 3 positions:
$4,000 price for both the ES futures contract as well as S&P 500 ETF (SPY)
$1M desired of exposure to the S&P 500
Subsequent +1% move in the S&P 500 ($10k profit)
Let’s walk through these 3 positions to show how the leverage works:
1. Cash Position
Transaction: Buy 250 shares of SPY
Cash value = $1M (250 shares x 4,000 price)
Notional Exposure = $1M
Note: I am using notional here for consistency, but that term is typically reserved for derivative positions
Cash return = 1% (10k/1M)
Notional return = 1% (10k/1M)
Cash return = Notional return
2. Fully Collateralized Futures
Transaction: Buy 5 ES contracts and hold $1M of cash
Cash value = $1M (in cash)
Notional Exposure = $1M (5 x $4k x 50 in futures)
Cash return = 1% (10k/1M)
Notional return = 1% (10k/1M)
Cash return = Notional return
Same as the cash position
3. Half Collateralized Futures
Transaction: Buy 5 ES contracts and hold $0.5M of cash
Cash value = $0.5M (in cash)
Notional Exposure = $1M (5 x $ 4k x 50 in futures)
Cash return = 2% (10k/0.5M)
Notional return = 1% (10k/1M)
Cash return > Notional return
The return on cash here is 2x the first 2 examples
Notice however, the notional return is the same as the previous examples. This is due to the underlying security having the same return in all 3 examples
The cash and fully collateralized positions result in equal cash and notional returns, while the half collateralized position results in 2x the return on cash despite the same notional return. By reducing the cash position by 50% in the half-collateralized scenario, you have both levered your position and freed up cash to invest elsewhere.
Options are a touch more complicated (a theme we’ll explore in future posts). As we discussed in Part 1, most derivatives contracts are assumed to have a constant delta of one and thus this number is not included in the equation. With options, you are working with a delta other than one, which results in a “delta adjusted notional.” So, $1 of notional exposure expressed in options is not necessarily the same as $1 in the other derivatives.
Operational Efficiency
Less trading
If you want to buy the S&P 500, you have a few options. You can buy:
All 500 stocks
An ETF
A futures contract (or a Total Return Swap)
Buying all 500 stocks can make sense if you plan to hold your position passively for a long time and have plenty of liquidity; however, buying all 500 stocks can take a while to trade. This wouldn’t be practical if you are managing your position actively.
ETFs can be expensive to trade. Once a fund reaches a certain size, there often isn’t enough liquidity to trade affordably. Institutional investors do trade ETFs, but this strategy is reserved for specific circumstances such as to complement another position.
A futures contract is the simplest of the three options if trading a large amount. It is easier to trade a futures contract as it is one transaction (as opposed to buying/selling all 500 stocks in the S&P) and is cheaper to trade than an ETF (as there is more liquidity).
Manage liquidity by keeping cash on hand
If you have large infrequent cash outflows, the settlement period that physical securities have, which can be several days, may not meet your liquidity needs.
Institutions have a couple of options:
Keep cash on hand and accept the drag on performance (which happens more than you think)
“Derivatize” a passive position by fully collateralizing it with cash
Both options allow you to meet your cash outflow, but option 1 will usually have a drag on performance, as markets tend to go up over time. Under scenario 2, you are able to pick up the incremental return, and when the cash outflow comes, you can sell the derivatives contract, transfer the cash, and wait for the derivative to settle without the market exposure.
Ease of access to
Commodities
It is straightforward to own, custody, and trade most physical instruments like stocks and bonds, but what if you want exposure to something like oil? Owning a barrel of oil is complicated, to say the least. It is much easier to implement via futures or swaps.
Derivatives like futures and swaps allow investors to gain commodities exposure without having to deal with the actual commodity (i.e. transporting and storing a barrel of oil). This is a common approach for multi-asset strategies like Risk Parity funds.
Credit
Another version of this would be access to credit risk through CDX (credit default swap index) instead of the bonds themselves. When you purchase a credit instrument, you are taking on interest rate risk as well as credit risk. Those two risks have different economic environments where they do well.
CDX isolates the credit risk to create a cleaner exposure to credit without the interest rate risk. This makes it easier to create balance in the portfolio.
Risk Management
Risk management is an underappreciated, important topic (one I plan to write about extensively). The following will provide practical use cases without getting into what risk management is philosophically.
Return Enhancement
Selling covered calls is a common strategy for enhancing returns, on average. With this strategy, you own the underlying position and sell a call option as an overlay on top of that exposure.
At the option’s maturity, 1 of 4 scenarios will occur. The underlying security:
Goes down in value:
You lose money on your underlying position, but you collected a premium when you sold the call option, which helps offset the loss
Goes up in value less than the strike:
You make money on your underlying position, and you collected a premium when you sold the call option
Goes up in value over the strike, but less than the strike + the premium
You make money on the underlying position, collect the premium, but at expiration the person who bought the call option exercises that option
You have to sell your underlying security at the strike price, forgoing some returns
However, you are still net positive as you capture some of the underlying security’s gain and the call option premium
Goes up in value more than the strike price plus the premium
This is similar to scenario 3 above, but in this case, you lose out on the gains beyond the strike + premium
If executed correctly, you increase your returns under most circumstances.
Options for Directional Bets
Note: This section assumes a basic understanding of options.
The asymmetric payoff profile of options make them useful for maximizing high conviction bets. If you do your due diligence and find a large mispriced stock, rather than buying/shorting the stock, you can express the idea by buying a call/put to juice your returns and manage your downside.
Let’s walk through an example to compare the different payoff profiles of expressing a long position via stocks and call options. For simplicity, let’s only focus on varying the strike price, and only purchase the calls (no spreads).
Buying the stock: You are linearly exposed to the outcome of the stock. Dollar for dollar, if the stock moves, you gain or lose the same amount. You could amplify returns through leverage, but then you are amplifying your potential downside as well.
Ladder out call options: You can set a budget to spend on premium and spread that out across multiple options with different strikes. The further out the strike price, the cheaper the contract (all else equal). The more outsized your expectation the higher you can push your position and buy more contracts for the same premium.
Scenario: A company is currently in a high profile anti-trust lawsuit. My discounted cash flow (DCF) model points to the following probabilities:
5% chance of them losing and being down 25%
25% chance of them losing and being down 10%
50% chance of winning the case and being up 20%
20% chance of winning and the stock being up 50%
The current stock price is $100, and I am able to get the following position:
1x 102 call for $2
1x 105 call for $0.7
6x 130 calls for $0.05 each (total of $0.3)
The total premium spent is $3, which is my max loss.
Now, let’s look at what my return profile looks like at expiration based on my original probabilities:
5% probability of -3% vs -25% for stock
25% probability of -3% vs -10% for stock
50% probability of +30% vs +20% for stock
20% probability of +110% vs +50% for stock
Here is the full return profile:
There is a window where the options underperform the stock. Outside that window, an options position will outperform a stock position by capping your downside and amplifying your upside as more options kick in.
If I buy the stock, I am exposed to the full extent of the downside, and my expected profit (while high in this scenario) is not fully maximized. By implementing via call options, you can choose how much premium you are willing to risk, which caps your downside, and increase your exposure, if your directional bet plays out as you expect.
Note: Use caution with options. Timing and price are both needed to make money. You can be right at the wrong time and lose 100% of your premium.
Hedging
Hedging is an extensive topic that can range from using futures to move around your market exposure to buying puts to protect against a sharp sell off. One of the most common hedges and uses for derivatives is FX hedging.
If I know there is a large foreign denominated cash flow headed my way, I can take the opposite exposure in a forward contract between my home currency and the cash flow’s currency. This allows me to reduce the risk that changes in the exchange rate materially impact my performance.
If it is a deliverable contract, you can literally not have the cash on your books at all (or for only a brief time). If it is a non-deliverable forward (NDF), you will receive/pay the gain/loss.
Rebalancing
Overlaying Cash Flows
Transactions take time to settle (similar to how it takes days to transfer money between your bank accounts). During that settlement period, you might end up having a material mismatch between your target portfolio and your actual portfolio.
For example, if I am getting a redemption from a hedge fund manager, they move that position to cash before the transfer hits your account. This time period can be long in some cases, and if it is a large cash flow, you will have a cash drag on your portfolio’s return if cash underperforms risk assets (a safe assumption, 2022 aside).
One alternative is to buy futures in whatever asset class you plan on funding with that redemption. This will reduce the drag on performance that would otherwise experience in rebalancing.
Options Based Rebalancing
Similar to covered calls, there is an opportunity to pick up some extra return during rebalancing by selling a call/put if I know I am going to sell/buy a security.
By writing a call option, I can pick up some premium, and if the option goes in the money, I deliver the security, which I was planning on selling anyways.
There is an art to doing this. If you set your strike incorrectly, you might miss out on gains if the underlying moves beyond the premium you pick up.