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OPTIONS AND OPTIONS TRADING
A Simplified Course that Takes You from Coin Tosses to Black-Scholes
By ROBERT W. WARD The McGraw-Hill Companies, Inc.
Copyright © 2004The McGraw-Hill Companies, Inc.
All rights reserved.
ISBN: 978-0-07-144297-8
Excerpt
CHAPTER 1
What a Derivative Is and What It Isn't
INTRODUCTION
In the past 5 years the price movements in the markets have been positively spectacular. In fact, it might be more accurate to say that the markets seem to have gone volcanic, erupting and spewing fire in all directions before lapsing back into a period of relative quiescence. For a long, long time certain high- tech industries and individual stocks seemed as invulnerable and mighty as Superman: faster than a speeding bullet, more powerful than a locomotive, and able to leap above their 52-week highs with a single bound. To even seasoned traders the events of this period were startling, the price movements mind- numbing.
Since the invention of money, there has never been a period of boom and bust to rival the trillions of dollars made and lost in the stock and bond markets over the last several years. As such there has never been a more exciting time to be involved in the markets. We are living through an historical period. And it is not over yet.
As a result of this there has never been a more appropriate time or more of a need to be studying finance and investments than right now. This is true despite the fact that the markets are in the process of losing some of their allure as they give back a large portion of their gains. While many might believe that the party is over and it's time to wander off home, they are not seeing the bigger picture. Now, more than ever, there are growing opportunities for those who understand markets and the myriad financial instruments available to be traded. It's when the easy money's gone that knowledge and experience pay off the most. It is sad to say, but only a handful of people involved in the markets over the last 10 years really understood what they were doing. One of the oldest adages in the markets is: Never confuse brains with a bull market. Once again the wisdom of old proverbs is being proved true.
In the market reversals of the last few years so many investors have gone from being "geniuses" to "idiots" that the nation's intelligence seems to have dropped 20 IQ points. Many day-trading stock speculators, who were never burdened with the knowledge of how markets work, have gone overnight from millionaires to bankrupts as their technical trading methods plunged them into a death spiral of losses. This is a classic beginner's mistake that can be easily avoided with a little discipline and risk management. But this type of overreaching speculation has little to do with the search for knowledge about finance and investments. And it has little to do with rational, level-headed people. Only suckers are gullible enough to think that becoming rich overnight is easy. They have now learned the painful way that what looks easy isn't, that what you see is not what you get, and that taking high risks brings insolvency far more often than riches. Most of the short-term technical traders, who were spectacularly successful for a while, have now "crashed and burned," in the colorful vernacular of traders. It's tough out there. Much tougher than many thought when the money was coming in fast and furious. The ones who succeed from here on in will have to work harder and learn their craft more properly than they did before. They might even have to go back to the basics to learn what makes the markets and financial assets tick. If they're smart, they'll start with a book like this.
There are two primary reasons that studying finance and investments right now is a very good idea even though the markets are no longer in runaway "bull" mode:
1. The stock market boom attracted many millions of new, inexperienced investors over the past 10 years. Although they think their baptism of fire over the last few years has turned them into seasoned veterans, they are still novices who don't know what they're doing. The market has a lot more moves yet to show them.
2. The enormous growth in the numbers of different types of financial assets over the past 20 years is staggering. Very few people, even in the industry, can get a handle on all the changes. This creates opportunities for those who can understand what's going on and why.
Such a huge number of newcomers were lured to invest their nest eggs over the past 10 years that there are now millions of novice investors, more than ever before in the history of the markets, following dubious advice and strategies. And these investors are beginning to realize they are very, very lost and in need of help. The demand is bigger than it's ever been, and it is growing. Many of the newcomers would like to stay invested, but want to learn how to hedge their exposure and lower risk. This opens opportunities for those who know what they are doing when it comes to measuring risk and hedging it, and there are far fewer professionals qualified to do this than you might think.
Furthermore, this new group of inexperienced investors is likely to create good trading opportunities in the future as they chase the hot money trends, which has been their habit. The better you understand the markets, the more likely you are to recognize when the newcomers have occasion to start a stampede of overbuying or overselling which will make some investments more attractive than they ought to be. It is from such ideas that successful trading strategies are woven.
Alongside this is the enormous growth over the past 20 years in the number of different types of financial assets. Very few people can keep up with all the various financial products available. There have been more financial innovations in the last 2 decades than in the 4000 years preceding them. The markets have never been more alive or faster-growing. With change and innovation comes added complexity. Never have so many financial assets been so complicated and understood by so few! The financial innovations that helped spark this revolution are known as derivatives, and we will be getting very familiar with them since they are central to our studies.
The term derivative describes a new type of asset whose value is derived from the more familiar markets. That is to say that the centuries-old markets of stocks, bonds, and commodities have given birth to a whole new asset class that is derived from them. Derivatives always depend on their underlying parent markets to support them. Sort of like that black sheep brother-in-law who's been staying at your parents' house. Derivatives are similarly dependent on their underlying parent markets, but they never mooch beer money or run up the phone bill.
The most basic derivatives are options, forwards, and futures. It is our task here to come to grips with what they are and what they can do for us. Our primary focus is options, but as you will see, we need a nodding acquaintance with forwards and futures to get the whole picture. And that is a good thing, for it makes the financial world a whole lot clearer after a bit. Options, forwards, and futures are the building blocks and backbone of most of the derivatives out there. When you understand these three basic building blocks, you will understand the concept behind almost all derivatives.
This book is about learning options the easy way. That does not mean it will be a breeze, for anything worth knowing cannot properly be learned via speed- reading. It just means that there is a difficult, complex way to learn options (one that requires a Ph.D. in math) and an easier, more basic way for those of us who don't consider ourselves math geniuses. We are going to present the more basic course, and we think we can teach it better than anyone else has been able to. We also believe that a lot more people would learn options if they had the opportunity
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Excerpted from OPTIONS AND OPTIONS TRADING by ROBERT W. WARD. Copyright © 2004 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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