I Think I Think I Think (still thinking)

I really think a lot.

I have been thinking for one whole day on whether friday was a bottom.

Some Thoughts So Far

1. It was a panic. Well, futures were traded to limit down.

2. But there was no huge sell down that really clear all the selling pressure.

3. To some extent, I could view it as the selling pressure is not strong enough to push prices lower anymore.

4. For the first time in many months, I am considering selling my put warrants. I mean it. But monday is closed so I can't do anything.

5. HSI is probably going to shoot on monday. But again, there is nothing I can do about it.

In conclusion, I will make my decision on monday night anyway. Nothing much I can do. Fed's meeting on wednesday, GDP numbers on thursday.

I will want to talk about something else this week - Derivatives. I will try to do it in a structured manner, something that one of my college tutors commented about. Hopefully, you can learn in a much better way.

Derivatives

Let's begin with some definitions.

Derivatives: They are loosely defined as papers that derive their value from other underlying financial instruments. So a derivative on oil will derive its value from the real oil price. Usually, you only have to put up a small margin to own a piece of paper that has a notional value of say 10 times your margin. Simply put, to "virtually" own 100 barrels of oil that are worth 1 million dollars, you only have to put up 100k to your broker (10% of the value) for example.

What forms do they come in?

They are mainly your futures, options, warrants, swaps and forwards. Well, usually people use futures and options more often than the rest.

What are the common uses?

Well, money making instruments? By right, they are meant to reduce risk. For eg, someone is holding huge amount in stocks. He is quite afraid of a potential selldown but he doesn't want to sell away his holdings (don't answer me why). So, he buys some derivatives, put options to be exact, such that he will reduce some of his losses if the market turns sour. They usually call this hedging.

But, by left...

They have been used for speculation purposes mainly. Speculation is the key word over here.

So... why is it so dangerous?

I have mentioned OTC derivatives before in the possible demise of USA part I. So do refer back again.

More Insight Please...

This is something that I have thought of. Something really fuzzy and yet, I think it really explains why it is so dangerous.

From a normal person point of view, when he faces derivatives, the first thing on his mind is the gains. Believe me, the potential for gains totally out-weighs the risk that everyone knows.

The reason for this is pretty simple. Most people tend to believe that they will be on the right side more often than on the wrong side. They will picture how much money they are going to make with it rather than how much money they will lose and so on.

Furthermore, we all want to make money. Greed is "good". Imagine this, I buy a stock, thinking that it will go up. It does go up 10% in the end. But if I buy a derivative on the stock. If the stock goes up 10%, I earn more than 50% (for e.g.). The mentality is this - for the very same position, I earn more using derivatives (I know about the losses but...). In fact this is exactly what I feel when I first come in contact with derivatives. I go for more volatile ones such as short maturity dates, out of money warrants. I lost quite a fair bit =).

To sum things up, it is human nature as work. We, as humans, are overwhelmed by greed.

Even More Insights - Bank's Perspective

Using this analogy, we can try to think from the standpoint of a bank. Well, banks are supposed to manage risk properly. They handle lots of money. Think of it this way...

1. The world economy has been good.

2. Stock market has been on a crazy bull run since 1980 for 20 years.

3. There is too much money everywhere because money is no longer pegged to gold anymore and there is a printing machine.

As a bank, during rosy times, where everyone is earning money and competing how much money you earn, derivatives become a money making tool more than hedging tool to them. A bank will worry more about how much money they make rather than how much money they might lose. They anchor too much on their past successes and are getting complacent. Because of the competitiveness among the banks, the only way to better one another is through derivatives. Banks are not only hedging their positions but they are also making these derivatives bulk of their holdings as well. Banks become greedy to some extent. Not only do they purchase normal derivatives, they go into more unique, creative derivatives to complicate things.

The Financial System

The whole system has turned into a gambling den. Everyone is betting heavily using these derivatives. Everyone has turned to a speculator because of past successes and greed. The idea of doing the exact same thing that yield two different results where the latter is much better, covers the underlying risk that comes along with the latter decision. Again, people ignore the other side of the coin. They feel that one side is much heavier than the other.

Today, we are faced with a global financial system meltdown because of greed and complacency. Yet, these people are not learning their lesson. They plead to others to save them.

Hopefully, this is a much better explanation for derivatives. The previous is good as well, just that it covers another part of it and its pretty dry.

I will make my decision on monday and probably put an update here.

P.S: sgdividends, my msn is xeron_knight@hotmail.com. Feel free to add me =) Thanks