The most important of all options in the financial markets is whether to use them but by no means ignore them. In both cases you have to understand them and go even beyond: Destination Derivatives.
It reminds of an excellent book by Frank Herbert : Destination Void. Nevertheless any similitude is to avoid.
Personally, I include them (derivatives) into my universe of dealing with financial information. It’s a great challenge to deal with them in an appropriate way due to their complexity.
After intensive study of « Options Futures, and Other Derivatives » [John C.Hull] and having already experienced the implementation of some solutions to derivatives portfolio management for the first French deposit bank (CDD), I came back to my very, very first reading in the domain. I reread what Peter Lynch « One Up Wall Street » said about the options and if it still had the same “influence” on my thinking as when I started dealing with stocks.
It’s chapter 19 of his famous book « One Up Wall Street » that I’m talking about (« Options Futures, and Shorts »). For those who don’t know I explain that Peter Lynch was the most successful money manager ever while leading to the summits the famous Fidelity Magellan Fund. He’s retired by now but his book preserves all its poignancy.
I will reconstruct the most pertinent points from Peter Lynch book. I find them hilarious and I keep them like a background music turning on in the back of my head. Extremely relaxing after having waded through Itô lemma; barrier options, Greek letters and Monte Carlo simulations on American options.
[ 1 ] « I’ve never bought a future nor an option in my entire investing career, and I can’t imagine buying one now. (…) That’s not to say that futures don’t serve a useful purpose in the commodity business. »
[ 2 ] « Reports out of Chicago and New York, the twin capitals of futures and options, suggest that between 80 and 95 percent of the amateur players lose (…) Those odds are worse than the worst odds at the casino or at the racetrack, and yet the fiction persists that these are ‘sensible investment alternatives’ »
[ 3 ] « Large potential return is attractive to many small investors who are dissatisfied with getting rich slow. Instead they opt for getting poor quick. »
[ 4 ] « It (option) regularly expires worthless – after which the option player must buy another option, only to lose 100 percent of his or her money once again. »
[ 5 ] « The worst thing of all is that buying an option has nothing to do with owning a share of a company. When a company grows and prospers, all the shareholders benefit, but options are zero-sum game. For every dollar that’s won in the market there’s a dollar that’s lost, and a tiny minority does all the winning. »
[ 6 ] « In the multibillion-dollar futures and options market, not a bit of a money is put to any constructive use. It doesn’t finance anything, except the cars, planes, and houses purchased by the brokers and the handful of winners. »
[ 7 ] « There’s a lot of talk these days about the use of futures and options portfolio insurance to protect our investments in stocks. Part of the insurance program required them to automatically sell off stocks at the same time they were buying more futures, and the massive automatic selling drove the market lower, triggering more buying of futures and more selling. Among the plausible causes of the October collapse, portfolio insurance is a principal culprit. »
[ 8 ] « Warren Buffet thinks that stock futures and options ought to be outlawed, and I agree with him. »
The message from Peter Lynch is very poignant that’s why good understanding of derivatives is crucial to take any attitude towards what he says.
Some deep insight could be obtained from Emanuel Derman « My life as a Quant ». Being a Wall Street« geek » and a quantum physicist in his first professional career Emanuel Derman’s plunge into the domain of derivatives is out of common.
Derman stresses the profound and intrinsic difficulty in mastering the domain in his words : « We are still on a darkling plain. If you are a theorist you must never forget that you are travelling through lawless roads where the local inhabitants don’t respect your principles. » It’s far from the precision of Einstein’s E = mc² but as he says , a theoretical purist finds a « (…) measure of contentment in (…) intuiting, inventing, or concocting approximate laws and patterns (…) and it may be the best anyone can hope for. »
« One Up Wall Street » by Peter Lynch
« Options Futures, and Other Derivatives » by John C.Hull
« My life as a Quant Reflections on Physics and Finance » by Emanuel Derman