Stock Markets Exposed

Are performance of stock derivatives affected if stocks do not perform as expected?

Since there are so many derivative products from stocks and many invest in them believing they are safer than investing in stocks, should it be considered a better investment or an additional investment for someone who wants to diversify their portfolio? Also, can you insure these investments from depreciating drastically? What are some investments that carry a safety net, e.g. does not go down more than X% and still X% above initial purchase value? Can you provide an example how an initial investment of $22 Mil yield an annual return of $10 Mil pre tax?

Public Comments

1. I would use derivatives as an insurance policy to have a good night sleep, because derivatives can limit your potential loss, although it does not come without a price (like insurance premium). For example, you invest in Google shares, but you're afraid that the stock price might suddenly go down. To hedge this risk, you buy a put option, which will give you the right to sell the stock at a predetermined price (so called strike price). So, you will limit the loss to a fixed %. The price you have to pay for it is the price of the put option. So, even if you buy "at the money" (strike=current stock price ) or "in the money" (strike > current price) put, you still can suffer a potential loss on your total investment, because you paid for the put. But you will know for sure the minimum return you will get. A combination of a put and a call, or shorting some of the derivatives will allow you to limit both upside and downside. A guaranteed no-loss investment will a have very limited upside potential. Why not to buy Government securities instead? In your example you are asking for 45% annual return. Portfolio with such expected return will carry a lot of risk.
2. Here is a way you can use derivatives to limit risk while reducing transactions costs. Say you want to buy $10,000 worth of stock. Instead of buying $10,000 and then hedging with a put. Just invest 5% ($500) in calls three to six months out. Invest the remaining 95% in CDs or T-bills. Interest earned on these will help pay for the 5% risked in calls. In this fashion you have all the upside potential of the stock for several months, with very little downside risk. You are well insulated from unforseen market closures as well. 45% is a big expected return. If you are able to beat the S&P500 each year, you are doing a good job.