By Eli Levi, Business Editor
When investing, it is helpful to know some of the terminology associated with various financial services. Derivatives, options, delta, and volatility are all some examples of these different terms.
A derivative is a complex type of financial security. Some examples of derivatives include options, forwards, swaps, or futures. Options are exactly as the name implies: an option to exercise a specific action. The option gives you the right to buy or sell shares of stock. A “call” option gives the owner the right to buy a stock at a specific price in the future. The owner of a “put” option buys the right to sell a stock at a specific price in the future. Options are used as a way to hedge the upside or downside of a stock. If I own stock but I want to hedge my potential downside, I would buy a put option. For example, if I bought a stock at $100 and I wanted to protect my downside, I would buy a put option at $98 giving me the right to sell the $100 security at $98, regardless of whether the stock price drops below $98. This brings my total possible downside or risk to only $2 as opposed to the full $100 (if the actual stock dropped to $0).
Generally speaking, the movement of any given stock affects the price of the different options associated with that stock. This is called the delta. As the underlying security (stock) changes in value, so does the price of the options attached to that security. When a stock’s price changes it is called volatility. Volatility refers to the amount of movement to either the upside or the downside of stocks. The more movement the higher the volatility; the less movement the lower the volatility.
Another important term is futures or futures market. A future is another traded asset that trades based on the perceived future value of something. The futures market is in many ways similar to the stock market, but trades differently. For example, if someone is trading wheat futures and frost destroys several silos of wheat, the price of wheat futures would increase. If supply decreases then price increases. There are futures markets for most commodities and even some indices.
One commodity whose futures market is illegal is the onion futures market. The United States banned the onion futures market because in 1955 Vincent Kosuga and Sam Siegel cornered the onion market, shorted it, and dumped their onion shares on the market making millions in the process. Vincent and Sam bought enough shares of the onion market to allow them to manipulate the price of onion shares, otherwise known as cornering the market. Once Vincent and Sam cornered the onion market they turned heavily short, in other words, they bet against the onion market (and that the onion market and its assets will decrease in value). The regular way a stock is shorted is by borrowing a share of the stock and selling it immediately. If the stock loses value, the bet succeeds; the stock is bought back at the lower price and the cheaper stock is returned to the person that it was borrowed from. Vincent and Sam used different methods to short the onion futures market but the idea holds. After the duo shorted the onion market they dumped all of their onion shares on the market creating an abundance of shares causing the price to drop significantly. This played right into Vincent and Sam’s plan because, again, they had bet against the onion market. On August 28, 1958, the onion futures market was outlawed due to this incident.
Speaking the language of the markets is the first step in understanding them and is a step in the direction of being able to use them to our benefit.