Options
From 123CFD
Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, buying a call option provides the right to buy a specified amount of a security at a set Strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party that sold, or wrote, the option must fulfill the terms of the contract.
The theoretical value of an option can be determined by a variety of techniques, including the use of sophisticated option valuation models. These models can also predict how the value of the option will change in the face of changing conditions. Hence, the risks associated with trading and owning options can be understood and managed with some degree of precision.
Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions, that have negotiated separate trading and clearing arrangements with each other. Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation.
Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.
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[edit] Contract specifications
Every financial option is a contract between the two counterparties. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications
- whether the option holder has the right to buy (a call option) or the right to sell a put option
- the amount and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock)
- the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise (options)exercise
- the expiration date, or expiry, which is the last date the option can be exercised
- the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount
- the terms by which the option is quoted in the market, usually a multiplier such as 100, to convert the quoted price into actual premium amount
[edit] Types of options
The primary types of financial options are:
- Exchange traded options (also called "listed options") is a class of exchange traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfilment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include
- stock options,
- commodity options,
- bond options and other interest rate options
- index (equity) options, and
- options on futures contracts
- Over-the-counter, or OTC options are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include:
- interest rate options
- currency cross rate options, and
- options on swaps or swaptions.
- Employee stock options are issued by a company to its employees as compensation.
[edit] Valuation models
The value of an option can be estimated using a variety of quantitative techniques, although most commonly through the use of option pricing models such as Black-Scholes and the binomial options pricing model.
In general, standard option valuation models depend on the following factors:
- The current market price of the underlying security,
- the strike price of the option, particularly in relation to the current market price of the underlier,
- the cost of holding a position in the underlying security, including interest and dividends,
- the time to expiration together with any restrictions on when exercise may occur, and
- an estimate of the future volatility of the underlying security's price over the life of the option.
More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates.
The following are some of the principal valuation techniques used in practice to evaluate option contracts.
[edit] Risks
As with all securities, trading options entails the risk of the option's value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlier and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict.
In general, the change in the value of an option can be derived from Ito's lemma as:
where the greeks Δ, Γ, κ and θ are the standard hedge parameters calculated from an option valuation model, such as Black-Scholes, and dS, dσ and dt are unit changes in the underlier price, the underlier volatility and time, respectively.
Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model inputs, dS, dσ and dt, provided the changes in these values are small. This technique can be used effectively to understand and manage the risks associated with standard options. For instance, by offsetting a holding in an option with the amount − Δ of shares in the underlier, a trader can form a delta neutral portfolio that is hedged from loss for small changes in the underlier price. The corresponding price sensitivity formula for this portfolio is:
[edit] Pin risk
A special situation called pin risk can arise when the underlier closes at or very close to the option's strike value on the last day the option is traded prior to expiration. The option writer (seller) may not know with certainty whether or not the option will actually be exercised or be allowed to expire worthless. Therefore, the option writer may end up with a large, unwanted residual position in the underlier when the markets open on the next trading day after expiration, regardless of their best efforts to avoid such a residual.
[edit] Trading
The most common way to trade options is via standardized options contracts that are listed by various futures and options exchanges.
By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include:
- fulfilment of the contract is backed by the credit of the exchange, which typically has the highest rating (AAA),
- counterparties remain anonymous,
- enforcement of market regulation to ensure fairness and transparency, and
- maintenance of orderly markets, especially during fast trading conditions.
Over-the-counter options contracts are not traded on exchanges, but instead between two independent parties. Ordinarily, at least one of the counterparties is a well-capitalized institution. By avoiding an exchange, users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition, OTC option transactions generally do not need to be advertized to the market and face little or no regulatory requirements. However, OTC counterparties must establish credit lines with each other, and conform to each others clearing and settlement procedures.
[edit] The basic trades of traded stock options
These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging.
[edit] Long Call
A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares.
[edit] Short Call
A trader who believes that a stock price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.
[edit] Long Put
A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless and only lose his premium paid.
[edit] Short Put
A trader who believes that a stock price will increase can buy the stock or instead sell a put. Shorting puts is generally considered inappropriate for small investors. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the amount of the premium, the short will lose money, with the potential loss being up to the full value of the stock.
[edit] Option strategies
Combining any of the four basic kinds of option trades (possibly with different exercise prices and maturities) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.
Strategies are often used to engineer a particular risk profile to movements in the underlying security. For example, buying a butterfly spread (long one X1 call, short two X2 calls, and long one X3 call) allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss.
Selling a straddle (selling both a put and a call at the same exercise price) would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss.
[edit] Historical uses of options
Contracts similar to options are believed to have been used since ancient times. In the real estate market, call options have long been used to assemble large parcels of land from separate owners, e.g. a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the right — but not the obligation — to dramatize a specific book or script. Lines of credit give the potential borrower the right — but not the obligation — to borrow within a specified time period.
Many choices, or embedded options, have traditionally been included in bond contracts. For example many bonds are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early.
Privileges were options sold over the counter in nineteenth century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was fixed at a rounded-off market price on the day or week that the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets.
