Monday, July 23, 2012

Options, Futures And Fantasy Football (1)

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Professional football is one of the most popular sports in America.  Not satisfied with just watching their favorite teams, some sports fans developed a football game of their own in which they created their own teams composed of actual NFL players and matched their teams against teams organized by their friends.  In its most basic form, participants create their own fantasy teams with real players from the NFL.  Everyone who participates puts in an agreed amount of money at the beginning of the season.  Based on the actual performances of his or her chosen players in NFL games each week, the "owner" of a team wins points.  The owner of the fantasy team with the most points at the end of the real season wins the money.  The performance of a person's fantasy team is derived from the performance over the NFL season of the players he or she has picked.  Fantasy football has grown into a national phenomenon in the US and is played every week by millions of sports fans.

There is a similar investment "game" being played every day on various exchanges devoted to options and futures.  On an options/futures exchange, people buy or sell assets, the value of which is based upon or, to be more accurate, is derived from the value of a different asset.  Such assets are generally referred to as derivatives.  One derivative, an option, comes in two forms: the right to buy an asset at a fixed price (a call option) or the right to sell the asset at a fixed price (a put option).  In either case, the option expires at a predetermined time, after which it is no longer enforceable.

Options have a long history.  During the tulip craze in 17th century Holland, there was a market for not only the actual tulip bulbs, but also for options on the bulbs. Options have been used by farmers for centuries.  The farmers' problem is the possibility that the price of the crop they plant in the spring may drop by harvest time to such a degree that the farmer faces a loss.  By selling the crop in advance for delivery when harvested, the farmer will have a guaranteed return on the crop.  The purchaser of the option on the crop, maybe a food processor, has secured delivery at a known cost.  Traders buy options and hope to realize a profit if the market price of the crop has increased by harvest time.  Supposedly, there was an exchange in Japan in the 18th century for rice farmers to sell their crop before the harvest. 

The Chicago Board of Trade (CBOT) was established in 1848.  Forward contracts for various commodities on the CBOT were standardized around 1865 and have been traded on that exchange ever since.  Today, there are numerous options exchanges around the world trading in virtually every type of commodity.  Forward contracts in financial instruments were introduced in Chicago in the 1970s and have grown rapidly world wide ever since.

The appeal of options to traders is that the profit potential is large while the loss is limited to the price paid for the option if it expires without being exercised.  Much less money need be invested in order to have a chance at a profit.  As an example, assume you have decided that a particular stock is going to increase in price.  The stock is trading at $10 per share and you have $100 to invest.  For purposes of this example, we will ignore the transaction costs, so you buy 10 shares.  Assume you are right and  the price goes to $20 per share in three months.  You will have doubled your investment.  If, however, you had purchased a publicly traded option or future contract on that stock with your $100, your gain might be more than if you had just purchased the actual stock.  The value of your investment tracks the value of the underlying stock, increasing or decreasing in step with the security.  In order to increase the potential profit, derivatives traders will borrow money from the broker (a margin loan) and invest the loan proceeds.  As a result, the profits could be much greater than if a person were to simply purchase the underlying stock with or without a margin loan.

In the next blog we will look at other derivatives.

Comments are always welcome.

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