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 Option

Commodity, Futures
In finance, an option is a contract whereby one party (the holder or buyer) has the right but not the obligation to exercise a feature of the contract (the option) on or before a future date (the exercise date or expiry). The other party (the writer or seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium.

Most often the term "option" refers to a type of derivative which gives the holder of the option the right but not the obligation to purchase (a "call option") or sell (a "put option") a specified amount of a security within a specified time span. (Specific features of options on securities differ by the type of the underlying instrument involved.)

Types of option

Historical uses of options

Contracts similar to options are believed to have been used since ancient times. For example, Aristotle wrote about Thales, who bought the option to use olive presses during the next harvest. 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 the market price on the day the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets.

Real options

A real option is a choice that an investor has when investing in the real economy (i.e. in the production of goods or services, rather than in financial contracts). This option may be something as simple as the opportunity to expand production, or to change production inputs. Real options are an increasingly influential tool in corporate finance. They are typically difficult or impossible to trade, so lack the liquidity of exchange-traded options.

Traded options

also called "Exchange-Traded Options" or "Listed Options"

Traded Options are Exchange traded derivatives, as the name implies. As for other classes of exchange traded derivatives, they have: standardized contracts; quick systematic pricing; and are settled through a clearing house (ensuring fulfillment.)

Vanilla and exotic options

Generally speaking a vanilla option is a 'simple' or well understood option, whereas an exotic option is more complex, or less easily understood. European options and American options on stock and bonds are usually considered to be "plain vanilla." Asian options, lookback options, barrier options are often considered to be exotic, especially if the underlying instrument is more complex than simple equity or debt.

The option contract

For the option purchaser (also called the holder or taker), the option:

  • offers the right (but imposes no obligation),
    • to buy (call option) or sell (put option)
    • a specific quantity (e.g. 1 contract= 100 shares)
    • of a given financial underlying (e.g. shares)
    • at an agreed price (exercise or strike price), or calculable value. For example the value can be calculated based on a reference rate or something else such as the average price of an underlying asset, as measured at agreed-upon intervals during the life of a contract, i.e. the Asian option.
    • on one or more call dates
  • in exchange for a premium (option price).

The counterparty (option writer / seller) has an obligation to fulfill the contract if the option holder exercises the option. In return, the option seller receives the option price or premium.

Option frameworks

  • The buyer assumes a long position, and the writer a corresponding short position. Thus the writer of a call option, is "short a call" and has the obligation to sell to the holder, who is "long of a call option" and who has the right to buy. The writer of a put option is "on the short side of the position", and has the obligation to buy from the taker of the put option, who is "long a put". See the basic option trades below.
  • The option style determines when the buyer may exercise the option. It will affect the valuation. Generally the contract will either be American style - which allows exercise up to the expiry date - or European style - where exercise is only allowed on the expiry date - or Bermudian style - where exercise is allowed on several, specific dates up to the expiry date. European contracts are easier to value.
  • Due to the "American" style option having the advantage of an early exercise day (i.e. at any time on or before the options expiry date), they are always at least as valuable as the "European" style option (only exercisable at the expiry date).
  • Buyers and sellers of exchange-traded options do not usually interact directly - the futures and options exchange acts as intermediary. The seller guarantees the exchange that he can fulfill his obligation if the buyer chooses to execute.
  • The risk for the option holder is limited: he cannot lose more than the premium paid as he can "abandon the option". His potential gain is theoretically unlimited; see strike price.
  • The maximum loss for the writer of a put option is equal to the strike price. In general, the risk for the writer of a call option is unlimited. However, an option writer who owns the underlying instrument has created a covered position; he can always meet his obligations by using the actual underlying. Where the seller does not own the underlying on which he has written the option, he is called a "naked writer", and has created a "naked position".
  • Options can be in-the-money, at-the-money or out-of-the-money. The "in-the-money" option has a positive intrinsic value, options in "at-the-money" or "out-of-the-money" have an intrinsic value of zero. Additional to the intrinsic value an option has a time value, which decreases the closer the option is to its expiry date.

Option pricing models

Models of option pricing were very simple and incomplete until 1973 when Fischer Black and Myron Scholes published the Black-Scholes pricing model. Scholes received the 1997 Bank of Sweden Prize in Economic Sciences (Nobel Prize of Economics) for this work, along with Robert C. Merton. In a departure from tradition, Fischer Black was specifically mentioned in the award, even though he had died and was therefore not eligible.

The Black-Scholes model gives theoretical values for European put and call options on non-dividend paying stocks. The key argument is that traders could risklessly hedge a long options position with a short position in the stock and continuously adjust the hedge ratio (the delta value -- one of the option sensitivities known as "greeks") as needed. Assuming that the stock price follows a random walk, and using the methods of stochastic calculus, a price for the option can be calculated where there is no arbitrage profit. This price depends only on 5 factors: the current stock price, the exercise price, the risk-free interest rate, the time until expiration, and the volatility of the stock price. Eventually, the model was adapted to be able to price options on dividend paying stocks as well.

The availability of a good estimate of an option's theoretical price contributed to the explosion of trading in options. Other option pricing models have since been developed for other markets and situations using similar arguments, assumptions, and tools, including the Black model for options on futures, Monte Carlo methods, Path Integrals, and Binomial options models.

In theory traders could buy cheap options and sell expensive options (relative to their theoretical prices), in quantities such that the overall delta is zero, and expect to make a profit. Nevertheless, implementing this in practice may be difficult because of "stale" stock prices, large bid/ask spreads, market closures and other symptoms of stock market illiquidity. If stock market prices do not follow a random walk (due, for example, to insider trading) this delta neutral strategy or other model-based strategies may encounter further difficulties. Even for veteran traders using very sophisticated models, option trading is not an easy game to play.

Option uses

One can combine options and other derivatives in a process known as financial engineering to control the risk in a given transaction. The risk taken on can be anywhere from zero to infinite, depending on the combination of derivative features used.

Note, by using options, one party transfers (buys or sells) risk to or from another. When using options for insurance, the option holder reduces the risk he bears by paying the option seller a premium to assume it.

Because one can use options to assume risk, one can purchase options to create leverage. The payoff to purchasing an option can be much greater than by purchasing the underlying instrument directly. For example buying an at-the-money call option for 2 monetary units per share for a total of 200 units on a security priced at 20 units, will lead to a 100% return on premium if the option is exercised when the underlying security's price has risen by 2 units, whereas buying the security directly for 20 units per share, would have led to a 10% return. The greater leverage comes at the cost of greater risk of losing 100% of the option premium if the underlying security does not rise in price.

Other instruments to manage risk or to assume it include:

  • Futures contracts
  • Forward contracts
  • Swaps

Employee stock options are also widely used as a compensation vehicle for employees and, in particular, senior executives of publicly traded corporations. However, employee stock options use is being curbed thanks in part to a decision by the Financial Accounting Standards Board (FASB) requiring that stock option grants are recorded on the income statement as an expense. Previously, options granted with fair market value exercise prices were not considered to have a cost to the company. This was a significant factor in their ascendancy as a compensation tool.

The basic option trades

Payoffs and profits from a long call.
Payoffs and profits from a long call.
Payoffs and profits from a short call.
Payoffs and profits from a short call.
Payoffs and profits from a long put.
Payoffs and profits from a long put.
Payoffs and profits from a short put.
Payoffs and profits from a short put.

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.

Long Call
A trader who believes that a stock's price will increase may 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 expiry 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.
Short Call (Naked short call)
A trader who believes that a stock's 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. Unless a trader already owns the shares which he may be required to provide, the potential loss is unlimited. However, such a trader who sells a call option for those shares he already owns has sold a covered call.
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 expiry 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.
Short Put
A trader who believes that a stock's price will increase can sell the right to sell the stock at a fixed price. This trade is generally considered inappropriate for a small investor. 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 premium, the short position will lose money.

Introduction to option strategies

Combining any of the four basic kinds of option trades (possibly with different exercise prices) 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.

  • Covered call — Long the stock, short a call. This has essentially the same payoff as a short put.
  • Straddle — Long a call and long a put with the same exercise prices (a long straddle), or short a call and short a put with the same exercise prices (a short straddle).
  • Strangle — Long a call and long a put with different exercise prices (a long strangle), or short a call and short a put with different exercise prices (a short strangle).
  • Bull spread — Long a call with a low exercise price and short a call with a higher exercise price, or long a put with a low exercise price and short a put with a higher exercise price.
  • Bear spread — Short a call with a low exercise price and long a call with a higher exercise price, or short a put with a low exercise price and long a put with a higher exercise price.
  • Butterfly — Butterflies require trading options with 3 different exercise prices. Assume exercise prices X1 < X2 < X3 and that (X1 + X3) /2 = X2
    • Long butterfly — long 1 call with exercise price X1, short 2 calls with exercise price X2, and long 1 call with exercise price X3. Alternatively, long 1 put with exercise price X1, short 2 puts with exercise price X2, and long 1 put with exercise price X3.
    • Short butterfly — short 1 call with exercise price X1, long 2 calls with exercise price X2, and short 1 call with exercise price X3. Alternatively, short 1 put with exercise price X1, long 2 puts with exercise price X2, and short 1 put with exercise price X3.
  • Box spreads — Any combination of options that has a constant payoff at expiry. For example combining a long butterfly made with calls, with a short butterfly made with puts will have a constant payoff of zero, and in equilibrium will cost zero. In practice any profit from these spreads will be eaten up by commissions

 

 

This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Option".




 
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