Investing reaches far beyond basic stocks, bonds, and mutual funds. There are many complex investment products designed to suit the needs and wants of more sophisticated investors. From options and futures to commodities and hedge funds, savvy investors attempt to maximize their earnings potential with a wide variety of financial instruments.
Keep in mind that although these vehicles might increase your profit potential, they can also expose you to higher risk. Be sure to assess your own risk tolerance and needs before investing in any of the products we'll cover in class. Often, investors have two distinct motivations for investing in derivative securities, leveraging and hedging.
For individuals with a high tolerance for risk, derivative securities allow them to take larger bets and earn higher rewards with smaller sums of invested money. In other words, derivatives enable investors to leverage their bets by using a small amount of money to control a greater size investment.
In the simplest terms, buying an option gives investors the right to either purchase or sell securities at a pre-determined level in the future. For example, you pay five dollars to acquire the right to buy a security at $100 before a set date. If that security rises above $100, you can buy that security at the pre-determined price of $100. In this example, as long as the stock rises above $105, you will make money. If the current market price rises to $125, you earn twenty dollars on a five dollar investment (excluding transaction costs) - a pretty fantastic return!
But if the stock had not risen above $100 during the set period of time, your option would have expired worthless and you would have lost 100 percent of your five dollar investment. It might not sound like a big loss, but had you bought the stock for $100 and it fell to ninety-five dollars, you would have only lost five percent of your total investment. So derivatives allow you to make a lot of money from a small investment, but they also make it possible for you to lose everything if the stock reacts differently than anticipated.
Hedging is a way to limit the downside risk in your portfolio. Let's say you own stock XYZ and you expect it to go up, but you want to be cautious in case the price falls. If the stock is trading at $100 today, you might want to buy a "put," for say, five dollars, with an exercise price of $100. This means that no matter what happens, you have the right to place, or sell, that security to someone else for $100. Additionally, you are guaranteed not to lose more than the five dollars you paid for the put.
If the price of XYZ rises above $100, you will make money on the stock you hold, but the put you own will expire worthless. As a result, even though you make money on the stock, you have still lost the five dollars protecting that position. So by protecting your position you will never "win" as you could have, but you also never have the downside risk that you would otherwise encounter.
Now, consider what would occur if the XYZ stock price were to fall to eighty dollars. In this case, you can still make money on the stock by "putting" it to someone else at the $100 strike price. You will earn twenty dollars on the transaction, minus the five dollars you spent on the option. In this situation, you win whether the stock price rises or falls, and the most you will ever lose is the five dollars you paid for the downside protection. Now, that's downside protection!
Keep in mind that although these vehicles might increase your profit potential, they can also expose you to higher risk. Be sure to assess your own risk tolerance and needs before investing in any of the products we'll cover in class.
Commodities are investments made in bulk goods such as grains, metals, and foods. For the most part, the price of the commodity is determined by supply of the commodity and the risk factors that may effect supply. Commodity risk is unique to the product being sold. For example, drought would have a bigger impact on grain prices than on copper. All commodity prices can be subject to acts of nature: fire, wind, drought, flood disease, and insect. They can also be affected by unpredictable governmental legislation, like import-export quotas, embargoes, subsidies, and foreign exchange re-valuations.
Some of the most popular commodities include farm products such as:
Because the supply of commodities is erratic, some commodities must be stored for future delivery. Contracts to deliver stocks of stored commodities are called "commodity futures contracts," or simply "futures." Futures contracts that are near expiration and are ready for the commodity delivery are called "spot contracts" instead of futures. The spot price is the price at which you can buy the commodity in the open market today, so it makes sense that spot and future's prices should be near each other as they reach maturity. This is because prices won't change much over that short period of time. Both spot and futures contracts are traded on the commodity exchanges.