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May 31, 2004

Equity Pros Join the Club: The Days of Trading Exclusively in One Asset Class Are History

By Mark Longo

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  • Equity Pros Join the Club: The Days of Trading Exclusively in One Asset Class Are History

Traders on the buyside and sellside - from market makers to portfolio managers - are in a jam. Terrorism, military conflict and economic uncertainty are responsible for a tough trading environment. Many stocks are at a fraction of their record values of March 2000. So it is no surprise that traders must find ways to dramatically improve returns while simultaneously protecting themselves against

adverse market conditions. Out of sheer desperation, many are looking beyond equities to an entirely different asset class derivatives.

Sure, many financial professionals consider derivatives to be forbidden territory. Even Warren Buffet is careful about these instruments. The Oracle of Omaha has referred to derivatives as "financial weapons of mass destruction." There are good reasons for this widespread fear. Most of the headline-making financial disasters of the last quarter-century have included derivatives. The collapse of Barings, the meltdown of Orange County and the unraveling of Long Term Capital can all be pinned squarely on derivatives. There are even those who say that the crash of '87 began in the derivatives pits of Chicago. On Wall Street, derivatives markets are commonly referred to as shadow markets because of their arcane and intricate financial instruments. However, those who master the secrets gain access to an exclusive club. That club is now opening its doors to more pros from the equity side.

In recent years, one class of derivatives has gained particular notoriety - options. They have, of course, been viwed as the trappings of greedy CEOs and destroyers of many dot com fortunes. However, they are also the most powerful tools available to equity traders. Any market maker, trader or portfolio manager who is not familiar with these instruments is missing out on an amazing world of trading possibilities.

The technical definition of an option is the right to buy or sell a specified security at a specified price by a specified date. There are two basic types of options: calls and puts. Calls give you the right to buy a security at a specified price by a specified date. Puts, as you can probably guess, give you the right to sell a security at a specified price by a specified date. How can trading the rights to buy or sell something increase the returns on your portfolio? The answer is leverage. Options allow you to put on large positions at a fraction of their regular cost. Let's say that you are interested in buying 1,000 shares of XYZ corporation. However, XYZ corporation is currently trading at $100 a share. This means that you would have to pony up $100,000 to buy the stock. That same trade, through the magical leverage of options, would only require the purchase of ten front month XYZ 100 calls. With those calls trading at $5, you could put on a position roughly equivalent to owning 1000 shares of XYZ stock for the relative pittance of $5000 (No, my math isn't wrong. Equity options have a multiplier of 100, but that is a discussion for another time.)