Economic Sabotage

[dieseltaylor]

On June 10 AFP Greenpeace was fined 4,000 Euros Under a new Danish

Anti-Terror Law for using an anti-GMO protest as a means of public

intimidation. Some, including the author of this piece, Lawrence A.

Kogan, believe other countries should follow Denmark’s example to

discourage what UK Prime Minister Tony Blair’s previous government

called 'economic sabotage'.

http://www.itssd.org/Publications/Rural%20News%20--%20Rural%20News_co_nz.pdf

It seems funny that destroying the US economy is not actually judged that harshly. Now it is being treated as a by-product of unfettered and uncaring capitalism and the penalties are civil.

Consider if you will if the people carrying out these deals had been founsd to be agents of another country/countries. Would the US public be happy with hauling them in front of the SEC and Congress. I think not.

Were these people playing the game smart enough to figure out the endgame. Of course they were. Deliberate or collateral sabotage of an economy deserves much more rigorous penalties. And I have no problem with retrospective legislation in this case if nothing is currently on the Statute books.

[Stalins Organ]

The defence mentioned below seems to be the same one claimed by the peaceniks who sabotaged the radomes at the Waihopai spy-base - ie they "honestly" believed they were doing a "greater good" - it worked for them too

Greenpeace-driven economic sabotage was catapulted into the public

limelight following the non-guilty jury verdict rendered on September 20,

2000, at the criminal trial of Greenpeace UK executive director, Peter

Melchett. Melchett and 27 other members of Greenpeace had been

criminally charged on July 26, 1999, with raiding (trespass), damaging

(vandalism) and trying to remove (theft) six acres of a GM maize crop that

were being grown by local Norfolk farmers for seed company Agr-Evo Ltd

(now the agrochemical company Aventis). At trial, Melchett successfully

invoked the subjective facts-intensive defense known in Britain as “the

Tommy Archer defense” which, as the Independent wrote, "relied on the

jury accepting that the defendant genuinely believed that the action would

prevent greater damage being done."

[dieseltaylor]

Yep the jury is going to represent public opinion. Thats great isn't it.

[ASL Veteran]

It seems funny that destroying the US economy is not actually judged that harshly. Now it is being treated as a by-product of unfettered and uncaring capitalism and the penalties are civil.

Consider if you will if the people carrying out these deals had been founsd to be agents of another country/countries. Would the US public be happy with hauling them in front of the SEC and Congress. I think not.

Were these people playing the game smart enough to figure out the endgame. Of course they were. Deliberate or collateral sabotage of an economy deserves much more rigorous penalties. And I have no problem with retrospective legislation in this case if nothing is currently on the Statute books.

I was under the impression that the recent economic collapse was caused by a 'mortgage meltdown'? I'm a little confused here .... nobody goes to Goldman Sachs to get a mortgage so I'm just curious what the specific role was that Goldman Sachs had in deliberately sabotaging the economy. Try to keep it simple for me though because I'm a simple guy .

[Stalins Organ]

As I understand it, no, you didn't get a mortgage from GS....but the banks you did get mortgages from sold them to investment bankers - including GS - who then traded the debt around for advantage to themselves.

Whatever it is that the infamous CDO's were - they included a considerable amount of "toxic mortgage" debt.

GS were selling CDO's off to various investors.

At the same time they were betting that those packages would collapse - taking what amounted to insurance against the value of those CDO's - if the value fell they would get a payout.

So on one hand they were encouraging people to buy them....but they were not telling people that they expected them to be worthless in short order.

Happy to be corrected....but I think that's the guts of it.

[dieseltaylor]

I have been trying to think of an analogy and the best I can imagine is this:

I want to race my horese against your horse and we agree to bet on the result. Now if I bet on your horse you might think it a bit odd. It also presents the problem that a bet needs two sides and if you and I are betting the same way ......

Fortunately for us there is a bookie [GS] who will provide people with the ability to bet on the race. Now the bookie knows that both the owners are betting against one horse but they do not mention that fact to the punters.

In fact the bookie is also betting on the duff horse failing and is prepared therefore to give great odds about the race and leans on the tipsters [rating agencies] who are pressured to say that the race is going to be close and the odds are pretty good. In fact the bookie leans on three tipsters just to make them keen to be his favourite. After all a tipster likes to have inside knowledge to report and look good.

SO how do I know my horse is not going to win. Well I have a friend called Paulson make up the feed for the horse and on the day of the race I am going to give him a fairly unhealthy diet. Its not like I have done anything illegal like dope the horse though. Of course if punters knew I was using Paulson feed for my horse they would probably run a mile as he has a really iffy reputation BUT if necessary I could tell them that Paulson is actually betting on the horse to win.

To take it back to the mortgage market. Mortgages used to be held by a Building Society or a Savings and Loan. That was the two parties at the horse race a direct transaction involving two people who had a vested interest in the house and the mortgage being repaid.

Then they invent the financial package where the loans can be bundled up and sold to another party. So I buy a bundle from your SL/BS for $10M covering 5000 mortgages and they service the loan and pass some of the interest on to me. Now I have been very cautious and I have only taken mortgages that have 10 years to run, there is lots of collateral and no defaults. Being thats pretty A grade then the SL/BS are only going to give me small interest - say 2% and keep the rest themselves.

From the SL/BS point of view they get a wodge of cash and can do mortgages, earning more commissions, and growing the company so everyone is happy. They do the process again and other companies get involved. Mortgages become easier to get and house prices rise. Of course there are only so many lenders with a good track record and equity in the house. To attract new money to take on the packages the SL/BS pay higher interest rates.

Of course higher interest rates may kill the market slightly but if the SL/BS offers some of the really good stuff and some of the riskier stuff overall with house prices going up buyers are still well covered by the value of the mortgages in the package. Now this is where it gets more fun. AIG will insure the package for me for added security and for very cheap rates. And if just one part of that package goes tits up then AIG will pay me and take the package out of myhands. Sweet, I would be an idiot not to do it.

Analogy time. You buy a fleet of cars for $1M and rent them out. If one guy stops paying then you trot off to AIG and say here are the keys to my car fleet, its yours now as I want to collect on the policy. Now if your fleet value was going up good for AIG but if the value is tanking it is a disaster.

I do wonder if I were unscrupulous whether I would pay off the AIG guy writing the policy to make it so one-sided. Or can I just rely on the pressure for him to meet underwriting targets and get bonuses. However there is another avenue I can use, I get a rating agency to confirm all the people I rent my cars to are leading members of the community to make it really easy for the AIG guy to give me a really low premium.

There is two more major wrinkle. I have a friend and he offers me one of his old packages and I buy part of it but lay off some of the risk by going to IAG or similar saying this package was rated AAA in 2003 so give me a very fine rate. They go OK write some more business and pocket the commission. Now the really exciting part is I decide to average my risk out and sell my goodish stuff which was $10M spread over 5000 mortgages. I decide what I will do is take a bet on various bundles of mortgages so my risk is spread over 20 bundles of mortgages which contain 100000 mortgages - must be less risky!

I can minimise my costs because there are companies offering me this kind of package. They will sell me synthetic bonds which are actually just bets on which way the market will go. This from Wiki

Joe Nocera wrote in the New York Times that prior to the creation of CDS and synthetic CDO's, you could have only as much exposure as there were mortgage bonds in existence. At their peak, approximately $1 trillion in subprime and Alt-A mortgages were securitized by Wall Street. However, the introduction of the CDS and synthetic CDO changed that. Unlike a “normal” CDO, which contained the bonds themselves, the synthetic version contains CDS — derivatives that “referenced” a particular group of mortgage bonds. Once synthetic CDO’s became popular, Wall Street no longer needed to actually originate new subprime loans. It could make an infinite number of bets on the bonds that already existed, as long as investors agreed to take the other side of the bet. One of the reasons synthetic CDO became popular was that the subprime companies were starting to run out of risky borrowers to make bad loans to in 2006-2007. Synthetic CDO enabled investors to bet against (take a "short" position in) mortgage bonds and housing prices more generally.[4]

The New York Times reported that from 2005 through 2007, at least $108 billion of synthetic CDO were issued, according to Dealogic, a financial data firm. The actual volume was much higher because synthetic CDO and other customized trades are unregulated and often not reported to any financial exchange or market.[5]

So there you have it, a foreseeable result. GS incidentally had a lot of insurance with AIG so were really happy that the US Govt paid out 100cents in the dollar. It was going to be 60cents in the dollar but the head honcho at GS called the US Treasury Secretary Paulson [- ex-GS] four times whilst he was in Moscow and the AIG deal got done at the higher rate. Plenty of people were pissed at that. BTW there are two different Paulsons in this story

ANd just to show how Bush bent over the US public for GS

In 2004, at the request of the major Wall Street investment houses—including Goldman Sachs, then headed by Paulson—the U.S. Securities and Exchange Commission agreed unanimously to release the major investment houses from the net capital rule, the requirement that their brokerages hold reserve capital that limited their leverage and risk exposure. The complaint put forth by the investment banks was of increasingly onerous regulatory requirements—in this case, not U.S. regulator oversight, but European Union regulation of the foreign operations of US investment groups. In the immediate lead-up to the decision, EU regulators also acceded to US pressure, and agreed not to scrutinize foreign firms' reserve holdings if the SEC agreed to do so instead. The 1999 Gramm-Leach-Bliley Act, however, put the parent holding company of each of the big American brokerages beyond SEC oversight. In order for the agreement to go ahead, the investment banks lobbied for a decision that would allow "voluntary" inspection of their parent and subsidiary holdings by the SEC.

During this repeal of the net capital rule, SEC Chairman William H. Donaldson agreed to the establishment of a risk management office that would monitor signs of future problems. This office was eventually dismantled by Chairman Christopher Cox, after discussions with Paulson. According to the New York Times, "While other financial regulatory agencies criticized a blueprint by Treasury Secretary Mr. Paulson proposing to reduce their stature — and that of the S.E.C. — Mr. Cox did not challenge the plan, leaving it to three former Democratic and Republican commission chairmen to complain that the blueprint would neuter the agency."[12]

In late September 2008, Chairman Cox and the other Commissioners agreed to end the 2004 program of voluntary regulation.

[ASL Veteran]

As I understand it' date=' no, you didn't get a mortgage from GS....but the banks you did get mortgages from sold them to investment bankers - including GS - who then traded the debt around for advantage to themselves.[/quote']

Hmmm, I was under the impression that Fannie Mae and Freddie Mac bought the mortgages and then created Mortgage backed securities which were then sold to investment bankers - including GS. Incidentally the F in both Fannie Mae and Freddie Mac stand for "Federal" (they are both acronyms.)

Not bad. I think it's important to make a distinction between a derivative (which is where all the wall street related problems were) and the underlying security. The key point missing there is that Fannie and Freddie were the ones buying the mortgages from banks, creating the mortgage backed securities, and selling them to wall street. Some on wall street then created derivative securities based upon those mortgage backed securities to use as a 'hedge' in the same way most derivatives are used. As it turns out the hedge positions were under collatoralized, but they had insurance through AIG and AIG probably never expected to have to cover all that they were insuring since they assumed that the risk was low. As to whether or not anyone knew about an imminent collapse or not, I would like to point out that the F in Fannie and Freddie (Federal) implied that the mortgage backed securities that they were peddling had the backing of the full faith and credit of the US government. Consequently rating agencies rated those securities as AAA the same as (or similar to) US government bonds. Now an argument could be made that Goldman Sachs near the collapse may have been tipped off by Paulson that a problem was a brewing and Goldman then cleared the decks and passed most of their risk to those unfortunate souls at Lehman Bros, Merrill Lynch, Morgan Stanley, and Bear Stearns, but to say that Wall Street as a whole knew that AAA rated securities that had the implicit backing of the Federal Government were worthless is a bit of a stretch I think.

[ASL Veteran]

I have been trying to think of an analogy and the best I can imagine is this:

I want to race my horese against your horse and we agree to bet on the result. Now if I bet on your horse you might think it a bit odd. It also presents the problem that a bet needs two sides and if you and I are betting the same way ......

I'm not too well versed in the specific derivative securities that were used, but I am pretty well versed in derivatives in general. Basically the writer and purchaser of the derivative are 'betting' against each other, although I wouldn't use the term betting as I think that gives people the wrong impression of what they are used for. Typically a derivative security is used as a hedge against something bad happening to any underlying securities that the writer or purchaser are holding. From what it sounds like though, Wall Street was guilty of under collatoralization of their derivatives and were, in effect, naked on those positions. If the derivatives were fully collatoralized then there wouldn't have been a collapse as the derivative hedge positions would have worked as they were supposed to. This is probably an area where some reform could be helpful, although Warren Buffet has already spoken out against the proposed derivative collatoral requirements in the new bill being discussed in Congress now.

Fortunately for us there is a bookie [GS] who will provide people with the ability to bet on the race. Now the bookie knows that both the owners are betting against one horse but they do not mention that fact to the punters.

In fact the bookie is also betting on the duff horse failing and is prepared therefore to give great odds about the race and leans on the tipsters [rating agencies] who are pressured to say that the race is going to be close and the odds are pretty good. In fact the bookie leans on three tipsters just to make them keen to be his favourite. After all a tipster likes to have inside knowledge to report and look good.

SO how do I know my horse is not going to win. Well I have a friend called Paulson make up the feed for the horse and on the day of the race I am going to give him a fairly unhealthy diet. Its not like I have done anything illegal like dope the horse though. Of course if punters knew I was using Paulson feed for my horse they would probably run a mile as he has a really iffy reputation BUT if necessary I could tell them that Paulson is actually betting on the horse to win.

Yes, the Paulson factor is a bit of an unknown. I'll agree that he gave Goldman an advantage if he decided to pick up the phone and call his buddies.

To take it back to the mortgage market. Mortgages used to be held by a Building Society or a Savings and Loan. That was the two parties at the horse race a direct transaction involving two people who had a vested interest in the house and the mortgage being repaid.

Then they invent the financial package where the loans can be bundled up and sold to another party. So I buy a bundle from your SL/BS for $10M covering 5000 mortgages and they service the loan and pass some of the interest on to me. Now I have been very cautious and I have only taken mortgages that have 10 years to run, there is lots of collateral and no defaults. Being thats pretty A grade then the SL/BS are only going to give me small interest - say 2% and keep the rest themselves.

From the SL/BS point of view they get a wodge of cash and can do mortgages, earning more commissions, and growing the company so everyone is happy. They do the process again and other companies get involved. Mortgages become easier to get and house prices rise. Of course there are only so many lenders with a good track record and equity in the house. To attract new money to take on the packages the SL/BS pay higher interest rates.

Of course higher interest rates may kill the market slightly but if the SL/BS offers some of the really good stuff and some of the riskier stuff overall with house prices going up buyers are still well covered by the value of the mortgages in the package. Now this is where it gets more fun. AIG will insure the package for me for added security and for very cheap rates. And if just one part of that package goes tits up then AIG will pay me and take the package out of myhands. Sweet, I would be an idiot not to do it.

Mortgage backed securities were an invention of Fannie Mae and Freddie Mac and have been around for decades. The Federal Government, through Fannie Mae (Federal National Mortgage Association I think is the official name) and Freddie Mac (which I don't remember except that the F is Federal), encouraged lending behavior by banks that fit within the political objectives of politicians of both parties by their willingness to buy mortgages of almost any risk profile (at the direction of Washington). In fact, regulators had targets that banks had to meet as to how many loans they made to various parties in order to ensure 'fairness' and 'home ownership' to minorities and other groups that were politically important. This goes back to Jimmy Carter.

Analogy time. You buy a fleet of cars for $1M and rent them out. If one guy stops paying then you trot off to AIG and say here are the keys to my car fleet, its yours now as I want to collect on the policy. Now if your fleet value was going up good for AIG but if the value is tanking it is a disaster.

I do wonder if I were unscrupulous whether I would pay off the AIG guy writing the policy to make it so one-sided. Or can I just rely on the pressure for him to meet underwriting targets and get bonuses. However there is another avenue I can use, I get a rating agency to confirm all the people I rent my cars to are leading members of the community to make it really easy for the AIG guy to give me a really low premium.

There is two more major wrinkle. I have a friend and he offers me one of his old packages and I buy part of it but lay off some of the risk by going to IAG or similar saying this package was rated AAA in 2003 so give me a very fine rate. They go OK write some more business and pocket the commission. Now the really exciting part is I decide to average my risk out and sell my goodish stuff which was $10M spread over 5000 mortgages. I decide what I will do is take a bet on various bundles of mortgages so my risk is spread over 20 bundles of mortgages which contain 100000 mortgages - must be less risky!

The risk part was not fully known because of the implicit backing of the Federal Government on the mortgage backed securities that Fannie and Freddie created. Anything backed by the US government is going to be rated AAA by a rating agency just as US Treasuries are considered - or at least used to be considered 'risk free'. That may not last too much longer, but for now Treasuries are still considered a low default risk.

I can minimise my costs because there are companies offering me this kind of package. They will sell me synthetic bonds which are actually just bets on which way the market will go. This from Wiki

Yes, derivatives are a form of bet, but they are generally used as hedges so it's not like going to Las Vegas or something like that (although admittedly they can be if someone is so inclined). Fundamentally a big wall street firm like Bear Stearns will be using derivatives to reduce their risk profile. If the derivative is undercollatoralized then you have a major problem for both sides of the transaction if the bottom falls out.

[Stalins Organ]

so much for trying to keep it simple then!

[Michael Emrys]

so much for trying to keep it simple then!

The essence of a good con game is to bury the con in enough complications so that you have time to milk it and get out of town before it is discovered. The best cons are buried in so much legal mumbo-jumbo that no action can be brought against you and you never have to leave town at all...unless you are worried about vengeful assassins.

Michael

[Stalins Organ]

It's not that the con job was complicated....it's that the explainations by the technocrats are complicated too!!

[Michael Emrys]

It's not that the con job was complicated....it's that the explainations by the technocrats are complicated too!!

Well what do you expect? They are in heavy obfuscation mode. This is more serious than their usual lite obfuscation mode.

Michael

[Stalins Organ]

I was expecting/hoping posters on this forum would not be in obfuscation mode at all!

[Michael Emrys]

I was expecting/hoping posters on this forum would not be in obfuscation mode at all!

It's the nature of the beast. Contemporary Economics is much like Ptolemaic astronomy. It still awaits its Keppler and Newton.

Michael

[dieseltaylor]

I decide to leave the Fannies out as I was also tying to UK Building Societies also. Effectively as you say the Fannies supported half the market. It is a great shame that corruption plays suh a large part in US upper echelons:

In 2000, because of a re-assessment of the housing market by HUD, anti-predatory lending rules were put into place that disallowed risky, high-cost loans from being credited toward affordable housing goals. In 2004, these rules were dropped and high-risk loans were again counted toward affordable housing goals.[11]

Wiki

The UK was also very corrupt in allwing very dubious mortgage processes. All of this however was really triggered by the influx of easy money into the marketplace where firms such as Goldman Sachs was lending up to 100 times its capital base. Complete lunacy.

The idea that one wrong deal would/should wipe-out the capital base was skated over by the buying of insurances, or hedging. I suspect that everyone in the game was thinking they would be out clear before the **** hit the fan. And I suspect that the laying of a risk in a dizzying spiral was also a game as nobody really wanted to question peoples ability to pay.

Far too much money was paid on results in an immediate time frame. If the money for bonuses was locked up for a decade then people who created the **** would get it back before pay-off. Incidentally switching between firms would mean bonus pot goes bye bye ..... otherwise bad guys would keep flipping jobs every year or so.

[dieseltaylor]

Well here is Newton

[ASL Veteran]

Hmmm, I'm not sure who is obfuscating things here - I was pretty straightforward in what I was saying :confused:. I managed to find an article from today that is a pretty good discussion of what I was trying to say (although I would still quibble with a few things that he says)

http://article.nationalreview.com/433223/the-senate-and-goldman-sachs/daniel-krauthammer

I guess maybe if I have time I'll type up a very simple explanation of how derivatives are used in the market - perhaps that will clarify things a bit.

[JonS]

If you know the answer, why did you ask the 'simple guy' question?

[Stalins Organ]

Hmmm, I'm not sure who is obfuscating things here - I was pretty straightforward in what I was saying :confused:.

You might think it straightfoward - but as a sample - this bit of yours is filled with jargon -

"From what it sounds like though, Wall Street was guilty of under collatoralization of their derivatives and were, in effect, naked on those positions. If the derivatives were fully collatoralized then there wouldn't have been a collapse as the derivative hedge positions would have worked as they were supposed to. "

"under callateralisation" - they borrowed more than they were worth?

"naked on those positions" something in the karma sutra??

"derivative hedge positions" - ???

Sorry but IMO you are not being simple when you are using "insider speak" to explain anything to someone wh is not an insider.

I managed to find an article from today that is a pretty good discussion of what I was trying to say (although I would still quibble with a few things that he says)

http://article.nationalreview.com/433223/the-senate-and-goldman-sachs/daniel-krauthammer

"But if the performance of different horses had statistically significant correlations to economic factors as various as crop production and manufacturing growth, mortgage rates and technology stocks — as the Goldman securities in question most certainly did — then a wager on them would not be a speculative bet but rather an informed investment engineered to hedge risk and optimize an investment portfolio. "

Only if yuo could accurately measure the effects....which I'm pretty sure we can not and half the problem is that ppl think we can, and/or jsut ignore teh ones we can't?

I guess maybe if I have time I'll type up a very simple explanation of how derivatives are used in the market - perhaps that will clarify things a bit.

I, for one, would appreciate it

[ASL Veteran]

If you know the answer, why did you ask the 'simple guy' question?

The intent was obviously to determine what the knowledge base was of those who are/were supportive of the initial post. I can only find that out by asking them to define things for me. The purpose is to allow people to 'discover' things on their own through questioning - I find that's more effective than to just tell someone something. Most people are more resistant to adjusting their positions or views on a matter if they are told something than if they are allowed to discover things on their own.

[ASL Veteran]

Only if yuo could accurately measure the effects....which I'm pretty sure we can not and half the problem is that ppl think we can, and/or jsut ignore teh ones we can't?

My intent was not to confuse - financial terms have very specific meanings and I'm not sure how to explain something easily without the use of the technical terms. Breaking up the technical terms into more ... every day language might make sentences a little awkward since each word would require it's own sentence to explain fully. When dealing with anything in the financial services industry there are very few things which are 'sure things'. Finance essentially deals with probabilities. If something is known for certain then everyone would profit from it - for example, if everyone on Wall Street knew that the mortgage industry would collapse then all the big firms on Wall Street would have made huge gobs of cash from it rather than being destroyed . The uncertainty factor is where hedging comes into play - you expect that outcome A is going to happen, but you can never be 100% certain that it will happen, so you 'hedge' by guarding against the opposite happening with a derivative. I have typed up an example of derivatives using 'options' and I'll post it shortly. I don't honestly know how easy it will be for the general forumites to understand, but it's about as simple as I can explain it. I'll be happy to answer any questions on it though if anyone needs a fuller explanation or is just curious.

[ASL Veteran]

Okay, a simple derivatives explanation (or rather, as simple as I can make it). Let’s pretend that Battlefront is now a corporation and say that I am interested in buying some stock in Battlefront Inc. Okay, if we assume that Battlefront (fake ticker symbol BFC) is trading at $10 per share and I buy 100 shares (a round lot) then I’ve just spent $1000. Now then, let’s imagine that Steve has announced that CM:N will be released on July 4 and I think it’s going to be a huge hit. I figure that once CM:N is released the value of my stock will increase to $15 per share because everyone will want to own a piece of Battlefront. The thing is though, that I’ve reviewed Steve’s record on his release date predictions and I think he’s going to miss that deadline. I still think that when the game is finally released it will be a hit. However, since I think the release won’t happen until sometime in August the price of my stock won’t go up until then, therefore I feel safe in writing a “Call Option” with a strike price of $12 per share and an expiration date of July 4. The Call Option is called a ‘derivative’ because it is a derivative of the stock I own. Each Call Option gives the person buying the “Call” the “option to buy” 100 shares of stock from me at a guaranteed price of $12 per share (the strike price). This is what’s known as a ‘Covered Call’ because the Call Option that I just wrote is covered by the 100 shares of BFC that I already own. In other words, I’m using my 100 shares of BFC as collatoral for my ‘call option’. If the call was Naked, then I would be writing the call without owning the stock and if the option was exercised by the purchaser I would have to buy the stock on the open market and sell it at a loss to the owner of my call option. I don’t have that problem though because my call option is ‘covered’ by the 100 shares of BFC that I already own. If the stock is currently $10 per share and the strike price is $12 per share then the Call Option is ‘Out of the Money’ because why would anyone want to pay a guaranteed $12 per share by buying the stock from me when it’s currently trading at $10 per share on the open market.

Okay, so far I own 100 shares of BFC and I have written a Call Option on my stock with a strike price of $12 and an expiration date of July 4. Why would I write this option? I would write the option because I’m going to sell it to someone else for a price – let’s just say that I sell it at a price of $8. If the stock price never goes above $12 per share then I just made $8 for doing nothing ….got it? So why would anyone buy my Call Option?

Let’s pretend that Stalin’s Organist is a nasty capitalist speculator who is absolutely positive that Steve will release CM:N a day early on July 3 and the stock price will skyrocket to $20 that day. If Stalin’s Organist is correct, he can buy my Call Option with a strike price of $12 from me for $8, he can then watch the price of BFC go up to $20 per share, exercise the option he bought from me, and buy 100 shares of BFC from me at a price of $12 per share. Since he bought my stock at $12 per share and the stock is trading at $20 per share on the open market he can immediately sell that stock on the market for $20 per share. Now then, Stalin’s Organist just made $800 (the difference between the price and the strike price) - $8 (what he paid me for the option) = $792 (Stalin’s Organist’s profit). I of course lose the same amount in terms of opportunity cost because if I hadn’t written the option then I would have been able to sell my shares of BFC at $20 instead of $12. Granted, I still made $208 since I bought the stock at $10 but still, $800 more is better. So you see, I write the call option and Stalin’s Organist buys the option and we are betting against each other. He thinks the price will go up and I think the price will remain the same. If the price doesn’t go above $12 before July 4 when the option expires then I win. If it does go up then Stalin’s Organist wins and I lose.

Now then, Diesel Taylor is a sophisticated investor who thinks that Steve will release CMN on July 4, but that he is certain that it’s going to be a total buggy disaster and the price of BFC stock will fall through the floor. He plans on “Shorting” BFC stock. Since Diesel is a sophisticated investor though he is going to “hedge” his position. Let’s just say that Diesel shorts BFC at $10 per share. What this means is that Diesel has sold 100 shares of BFC that he doesn’t own at $10 per share. He still has to buy BFC eventually in order to complete the transaction so by selling at $10 he assumes the price will fall to $5 per share and he will buy the stock back at that time. If he sells it at $10 and buys it at $5 then Diesel will make $500 because the stock lost value. If the stock goes up to $15 though … well then Diesel would have to buy his ‘Short’ position back at $15 when he sold for $10 and he would lose $500. Diesel isn’t the sort of guy who says “easy come, easy go” when money is involved, so he is going to hedge his position and limit his upside risk by buying my Call Option at a strike price of $12. This way, if CMN turns out to be a solid hit and the price goes up to $20 per share, Diesel can limit his loss to $2 per share plus what he paid me for my option (or a total of $208) by my guarantee to him that I will sell to him at a price of $12. Once again, Diesel and I are betting against each other if the stock price goes up, but this time Diesel is buying the option as a hedge in case his prediction of a BFC collapse doesn’t come true.

[ironbar]

If you bought the stock at $10 a share, issued a "Call option" at $12 a share, but sold it at $8- didn't you lose $2 a share?

[ASL Veteran]

If you bought the stock at $10 a share, issued a "Call option" at $12 a share, but sold it at $8- didn't you lose $2 a share?

No - because I didn't sell my stock, I sold an option to buy my stock at a price of $12 per share and the $8 is the money that is given to me by the person buying the option to buy my stock (just $8 for the single option, not $8 per share for 100 shares because they aren't buying my stock but rather the option to buy my stock). So you see, I sold my call option to Stalin and Diesel for $8 - that's what they are paying to me for the option to buy my stock at $12 per share. Of course, I'm not going to sell them an option that's in the money because then as soon as they bought the option from me they would exercise it - I certainly wouldn't want to do that. when I sold the call option the price was $10 per share so a call option with a "strike price" of $12 is out of the money (because they can only exercise the option they bought from me for eight bucks (for the single option) if the price goes up to $12 or more since that's the 'strike price').

One Call Option allows the purchaser to buy 100 shares of stock, so one call equals one hundred shares of stock but only if the option is exercised. I probably didn't make that clear in my example above because it's basically common trading knowledge that one option equals 100 shares - my apologies for that. The strike price is the price that the stock has to be over in order for the option to be exercised (or spent, or used, or consumed or whatever term is simpler). Keep in mind that the call option is a derivative of the underlying stock and not the stock itself, therefore the derivative trades separately from the stock and acts as it's own security - yet it's still tied to the underlying security because that's the security that the option is "derived" from.

[Kanonier Reichmann]

Please correct me if I'm wrong but in your example, a derivative is basically a written promise to sell the bundle of 100 shares once the market price reaches $12 provided the Option hasn't expired, correct? Therefore, you're receiving a one off payment of $8 in exchange for a piece of paper that promises the sale, subject to certain condiitions.

Regards

KR