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"Mr. Practical" On Leverage, Options, and Derivative-Fueled Crashes

•, by Mike Mish Shedlock

Leverage, Options, and Derivative-Fueled Crashes by Mr. PracticalOption contracts have been around since antiquity, ever since someone said, "if you do this, then I will do that". Clever people who knew how to intuitively price options (agreements/bets/contracts), making the "this" worth more than the "that", got ahead, accumulated wealth. With the advent of liquid markets came the ability to "hedge" options, and with that, the Black-Scholes model. Pricing options, even after the BS model was derived, is obtuse and so they are consistently mis-valued.

Options began trading as securities in the late 1970's and became part of a group of securities called derivatives: securities or contracts that derive their value from an underlying asset. All derivatives connote leverage in varying degrees with options being the most levered. But unlike most other more vanilla derivatives, options when employed properly serve a real purpose for investors/traders other than leverage: they segment risk into upside and downside and facilitate delineation of return profiles.

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