How do derivatives increase leverage

For example, the owner of a stock buys a put option if they want to protect the portfolio against a decline. This shareholder makes money if the stock rises but also loses less money if the stock falls because the put option pays off. Derivatives can greatly increase leverage. Leveraging through options works especially well in volatile markets. When the price of the underlying asset moves significantly and in a favorable direction, options magnify this movement.

For obvious reasons, high volatility can increase the value and cost of both puts and calls. Derivatives can greatly increase leverage—when the price of the underlying asset moves significantly and in a favorable direction, options magnify this movement.

Investors also use derivatives to bet on the future price of the asset through speculation. Large speculative plays can be executed cheaply because options offer investors the ability to leverage their positions at a fraction of the cost of an underlying asset.

Derivatives can be bought or sold in two ways— over-the-counter OTC or on an exchange. OTC derivatives are contracts that are made privately between parties, such as swap agreements, in an unregulated venue. On the other hand, derivatives that trade on an exchange are standardized contracts. There is counterparty risk when trading over the counter because contracts are unregulated, while exchange derivatives are not subject to this risk due to clearing houses acting as intermediaries.

There are three basic types of contracts. Options are contracts that give the right but not the obligation to buy or sell an asset. Investors typically use option contracts when they don't want to take a position in the underlying asset but still want to increase exposure in case of large price movement. There are dozens of options strategies but the most common include:.

Swaps are derivatives where counterparties exchange cash flows or other variables associated with different investments. A swap occurs many times because one party has a comparative advantage , like borrowing funds under variable interest rates , while another party can borrow more freely at fixed rates.

The simplest variation of a swap is called plain vanilla—the most simple form of an asset or financial instrument—but there are many types, including:. Parties in forward and future contracts agree to buy or sell an asset in the future for a specified price.

You need leverage because without it the hedged position has a good Sharpe ratio but its risk and expected return are very low.

You can further refine your strategy to capture the premium in convertible arbitrage by using derivatives bond futures to hedge your interest rate exposure and possibly even credit default swaps to hedge residual credit risk.

A wealth of research has shown that the return to a portfolio of futures constructed to follow those trends tends to be positive. And, arguably more importantly, this return pattern has, on average, a very low correlation with traditional markets. Furthermore, in a rare exception to most successful strategies, it has had its greatest success when movements of traditional markets have been extreme. All in all, a strategy that makes money, on average, does not suffer, on average, when equities decline and succeeds when the world is going mad in either direction is a valuable one, indeed.

But, at the risk of asking a question with a now obvious answer, to implement such a strategy, what do you need? Again, a strategy that we believe belongs in an institutional portfolio, and that can help achieve return hurdles while possibly providing some protection against the inevitable vicissitudes of markets which presumably did not end when the stock market hit bottom in March , is only possible if one is to accept a modest and prudent use of our bad boys.

The first step has been done. And improve it they do. Particularly when you make sure they are hedged strategies, not delivered with the embedded market exposure too often found in hedge funds. Our studies, using traditional asset classes plus a diversified set of hedge fund betas, shows that, at the same level of portfolio risk, an economically meaningful increase in expected return is possible.

They are valuable because they represent sources of return risk premiums not commonly present in traditional portfolios. You just need leverage and derivatives to turn them into a useful investable form.

Note the cumulative return since the worst of the financial crisis when, in some odd timing, we began trading this in a live portfolio.

Hedge fund betas did not suffer. However, most real-world hedge funds suffered, for they were and generally still are long the stock and credit markets. In other words, the average real-world hedge fund is not very hedged. The fascinating implication is that although hedge funds had a rough run during the fall of , it was mostly because of their market betas.

Of course, despite our defense of, and advocacy for, derivatives and leverage when used to diversify and expand opportunities, there are real dangers if they are used imprudently.

But beyond that, there is also bad implementation of good intentions. To start, leverage and derivatives should not be used to deceive. Leverage should not be implicit and unstated. Derivatives should not be vehicles for repackaging disallowed risks into allowable risks or, even worse, into hidden ones ask Greece.

In practice both tools rely to some extent on market liquidity. Leverage magnifies exposures and so magnifies transaction costs as well as returns, making portfolio rebalancing more expensive when bid-ask spreads are wide when liquidity is poor. More importantly, when leveraged investors with inadequate cash reserves and illiquid portfolios find the bid prices for their assets falling so low that lender collateral requirements cannot be met with available cash, they may be forced to unwind some leverage, which will be expensive.

In the futures markets margin requirements may be raised on a position too large to trade down efficiently. When inadequate cash reserves are held to support this position, portfolio sales may be forced, quite possibly at a time when markets are disrupted and trading is expensive. This is one case in which the long-term leverage embedded in equities is less dangerous than financial leverage taken on by a portfolio manager.

Please see this and more at fincyclopedia. In general, leverage or gearing can be defined as borrowing funds to make investments. In the context of derivatives trading, investors can control large positions in derivatives for little amount of outlay or even for nothing at all. A company that doesn't have enough capital to play financial markets can simply move between markets. In other words, it may shift its bets from a financial market the bond market, the stock market, etc into the derivatives market the futures market, the options market, and to a less extent the swap market.

After all, we have heard of government bodies, such as Orange County in California, that suffered great harm from using derivatives to increase risk. As well, no less an investment figure than Warren Buffett has referred to derivatives as financial weapons of mass destruction. However, derivatives can also be used to reduce risk. While municipal Treasurers may not use derivatives day to day, ONE Investments ONE may use them in specific ways in future investment strategies to manage risk.

What is a derivative? Derivatives are financial instruments that derive their value from other financial instruments, often stocks and bonds.

Their uses are many, ranging from leveraged strategies designed to increase risk to hedging strategies designed to reduce risk.

At ONE Investment, we do not permit external managers to use derivatives in a leveraged way or for speculative purposes. They may be used only when they are fully covered by a backing asset, e.

In the sidebar, we explain how derivatives can be used to leverage portfolios for better or for worse.