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Slimed by Association . . .

05/20/2011

As I expect the stock markets to be volatile for the summer and fall, my interest was piqued when I learned there was a lecture on the latest techniques in volatility management at the NAPFA Conference in Salt Lake City.  I was hoping to hear the latest research on cash allocation per asset class of risk or affordable retail hedges or even volatility ETFs.

Instead, it was the old information on strategies for the use of options.  There is the “covered call’ strategy, which I’ve used for certain income investors who don’t care if a particular stock gets sold without notice.  There is the “costless collar” strategy, which is great for investors who have a large, concentrated, low-basis single stock position.  There is the “protective put” strategy, which allows an investor to lock-in capital gains, IF they are willing to pay a big fee up front.  All of these and others are valid uses of options, not speculation!

It occurred to me that I have repeatedly lamented the systemic danger posed by derivatives, but options are also derivatives.  Technically, derivatives are any investment instrument whose value is “derived” from the value of something else.  For example, the value of a put or call on IBM cannot be determined without knowing the value of IBM.  Used in this fashion to limit risk, options are a good derivative.  Even when used for speculation by the gun-slingers, they are still okay, because they are known.

The bad derivatives are those made under the radar-screen, especially credit derivatives of all types.  Huge bets can be made against a company or even a nation (ask Greece) under cover of darkness, and then those same bad characters can work to destroy that company or nation in the daylight.  This is a danger to our financial system that was not addressed in last year’s financial re-regulation bill.  It was attempted but failed!

So, forgive me for lambasting all derivatives.  Some are good, some are okay, and some are downright evil . . .

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