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China Looks To Add Credit Default Swaps, Steven D. Dolvin

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Credit Default Swaps (CDSs) enable investors to hedge the risk of bond (or other credit securities) default. Like any derivative, they essentially allow investors to transfer risk -- from hedgers to speculators (or even between hedgers or speculators with different exposures). See article here, Reuters.

Nasdaq To Acquire Ise, Steven D. Dolvin

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Nasdaq is set to acquire the International Securities Exchange (ISE). The combined firm will manage six exchanges, representing 38 percent of US options trading. This will surpass the CBOE, which manages about 27 percent of the option trading market. See article here, Bloomberg.

Credit Default Swaps Signal Warning, Steven D. Dolvin

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Credit Default Swaps allow investors to hedge the risk of default on underlying debt, essentially acting as put options. Recently, CDS prices on the debt of banks such as Goldman Sachs and Deutsche Bank have increased in price, signaling a larger possibility of default. Many investors view CDS prices as a barometer of faith, thereby suggesting that bank stocks are poised for further declines. See article here, WSJ.

2 Days, $1 Million, Steven D. Dolvin

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Options allow investors to generate higher levels of returns (and losses) as compared to taking positions directly in the stocks that the options are derived from. For example, a recent MSN article discusses a trader that purchased $1.7 million worth of call options on AMAT. The stock price increased 5% in two days, resulting in a profit of $1.4 million, which is an 82% return.

Volatility And Derivatives, Steven D. Dolvin

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There are six primary inputs used to determine the price of a stock option: underlying stock price, exercise price, time to expiration, volatility of the underlying stock's price, market interest rate, and dividend yield on the underlying stock. Each has a particular relation to option value. For example, as stock price increases, the value of a call would increase, while the value of a put would decrease. For volatility, an increase in volatility has a positive impact on the value of both puts and calls, since payoffs are asymmetric. That is, no matter how low the stock's price goes, all …

Covered Calls, Steven D. Dolvin

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A Covered Call is created by purchasing stock and simultaneously writing a call on that stock. The position limits upside, as the stock will be called away if the price rises above the exercise price. But, the premium from selling the call provides extra income, which is the primary reason for executing such a strategy. See the article here, WSJ.

Options For Everyone?, Steven D. Dolvin

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Options (and derivatives in general) are often painted by the media as financial time bombs. While they can be used for speculative trading, they can also be used for hedging as well. Unfortunately, many smaller investors are not skilled in their use, which has led to significant losses for many. See article here, NY Times.

Weather Derivatives, Steven D. Dolvin

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Most people are aware of stock options or futures contracts on commodities such as gold and oil. However, the derivatives market is very diverse, including such things as weather derivatives. With hurricane season upon us, you may want to do some research on hurricane futures and options (http://www.cmegroup.com/trading/weather/hurricanes/hurricane.html). Essentially, these contracts allow insurers to transfer risk to other parties, such as hedge funds. See the article here, CME Group.

Selling Fear = Making Money, Steven D. Dolvin

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Buying put options is commonly understood to provide a measure of insurance against price declines. As such, the cost of options is strongly correlated to the amount of fear in the market. It might be prudent in these cases to make the opposite trade -- selling put options. The seller (or writer) collects the premium, which during times of fear is very large. The risk is a significant decline in prices. See the article here, Forbes.

Cds Trades Continue, Steven D. Dolvin

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JP Morgan recently announced a $2 billion loss, which renewed criticisms that originally surfaced during the credit crisis. While final details are still to come, initial reports suggest that much of the loss is attributable to the sale of Credit Default Swap (CDS) contracts. Similar exposures helped lead to the downfall of Lehman Bros., Bear Sterns, and AIG following the Crash of 2008. (See the article here, Fox Business.)

Shorting Via Options (Facebook), Steven D. Dolvin

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Following Facebook's IPO, investors were looking to short the stock. However, there was little (to no) available supply of shares to borrow. So, are we unable to create this position? Well, investors can resort to options.

Recall the Put-call parity equation:

S + P = C + K/(1+r)^t

If we rearrange the formula, we can create a synthetic (or replicated) position. So, if we wanted the equivalent of a short position in a stock:

-S = -C - K/(1+r)^t + P

Thus, to create a synthetic short, we would sell a call, short a t-bill (or borrow present value of …