4. When a derivative is the right tool

Derivatives 9: Derivatives in a real portfolio

You reach the end of the course with nine levels behind you and not a single winning strategy in the bag. That was deliberate. This module explains why, answers the question everything before it was preparing for, and closes the track.

Three uses in which a derivative is the right tool

Hedging a specific risk you already have. This is the original case, that of the farmer and the miller from level 1. There is an exposure you did not choose or that you cannot unwind without cost, and you buy the right not to suffer it. Requirements: the risk exists before the derivative, it is identifiable, and the hedge's expiry is tied to the moment it materializes.

Capping an exposure. Changing the shape of the payoff without changing its direction: replacing shares with long calls so that the worst case is a known number, putting a floor in place with a put, trimming both top and bottom with a collar. Here the derivative is not after return, it is after making the worst scenario fit within your wealth.

Expressing a thesis about volatility. It is the only one for which no substitute exists. If your view is that the market will move more than its price implies, or that the term structure of level 7 is wrongly sloped, there is no way of expressing it by buying or selling shares. Level 8 gave the structures and what kills each of them.

The substitute test and five warning signs

One question separates those three cases from everything else: can I get this without the derivative.

If what you want is more exposure to the market and the answer is yes, by buying more shares, the derivative is superfluous and only adds an expiry, a spread and margin. If you want less and the answer is yes, by selling part of it, the same applies. The derivative earns its place when the answer is no: what you want to change is the shape of the payoff, not its size or its sign.

When the answer is yes and the derivative is opened anyway, it is usually leverage by another name. These are the five signs:

• The justification starts with with the same money. That does not describe a hedge, it describes leverage.
• The selling point is that the premium is small. Module 1 of this level explained why that figure does not measure size.
• It leans on a hit rate. Level 6 showed a 95% hit rate coexisting with negative expectancy.
• The position takes in money up front and its worst case is not written down anywhere before it is opened.
• A very short expiry is chosen because time works in your favor. Level 4 gave the warning: theta grows at the end, but gamma grows with it and gamma is the one that decides.

The nine levels, one per line

• 1. Futures: the clearing house, margin, daily settlement and why a future's price is financing and not prediction.
• 2. Options: premium, intrinsic and time value, and the parity that stops call and put living lives of their own.
• 3. Volatility: implied against historical, the smile, what the VIX measures and why a risk premium exists.
• 4. Greeks: delta, gamma, theta, vega and rho, the breakdown of an option's movement.
• 5. Hedging: protective put, covered call, spreads and the question of when not to hedge.
• 6. When it goes wrong: the seller's asymmetry, margin, forced liquidation and four disasters with the same skeleton.
• 7. Term structure: volatility as a position, not as a parameter, and what the slope says.
• 8. Combined positions: straddles, calendars and ratios, and what kills each one.
• 9. Real portfolio: notional against premium, margin and liquidity, the full bill and this last question.

Where the academy goes next

• The three easy courses. Market theory, for microstructure and for reading a company; Macro, for rates, inflation and the cycle; and Costs, the shortest and the one that saves the most money.
• The other two intermediate ones. Math and statistics turns this course's suspicions into numbers: fat tails, multiple testing, out-of-sample validation. Risk and portfolio management answers the question of size that module 1 left open.
• The three hard tracks. Technical and Python is applied programming: data, a bias-free backtesting engine, modeling costs and margin, and connecting to a broker. Data and production is about making the information reliable and getting the system to trade on its own every morning. Both are where you measure instead of opine. The third, Expectations and edge, contains not a single line of code and is hard because of what it demands: what is priced into a price and where there is room left to disagree with it.

The useful order to continue in is Costs, then Risk and portfolio management, then Math and statistics.

Worked scenario: the same contract, two investors

Two people buy exactly the same put on an index: three months to expiry, strike 10% below the current level, premium equivalent to 1.2% of the notional covered.

The first has 300,000 euros in an index fund and needs to withdraw 60,000 in three months' time for a house deposit. She covers 100,000 euros of notional and pays 1,200 euros. She knows what risk she is covering, what it costs her and when it stops mattering. If the market rises, she will have lost 0.4% of her portfolio in exchange for a bad quarter not changing her plans.

The second has 20,000 euros and buys the same put for 1,200 euros because he thinks the market is going to fall. He covers a notional of 100,000 against wealth of 20,000: he is covering nothing, he has taken a bearish position of five times his wealth, with an expiry date on it. If the market does not fall within three months, he will have lost 6% of everything he has without anything in particular happening.

Same contract, same price, same delta, same expiry. The only thing that changes is whether there was a prior risk to cover. That is the lesson of nine levels.

Final warning

All of this material is education, not financial advice. Nothing written here is a recommendation to buy or sell anything, nor does it take into account your situation, your objectives or your risk tolerance. The historical cases illustrate mechanisms and anticipate nothing.

And the warning this course is obliged to repeat in its last line: derivatives make it possible to lose more than the capital invested. A short or leveraged position can leave your account owing money to the intermediary. If you trade with real money, do it on your own analysis, with a size that withstands the worst scenario you can describe and, if you need it, with an authorized professional.