OPTIONS HAVE MORE FUTURE THAN FUTURES- Lies, Lies and Damn Lies -6

Previous Post : Understanding Derivatives – Lies, Lies and Damn Lies -5

Options are the most versatile financial instruments. Though they are the simplest of financial instruments, they are considered to be mysterious and complicated. As a result most of the set backs in financial markets are attributed to options most often mistakenly. Options are actually designed to hedge risks and transfer the risks to speculators. Their bad side comes up when speculators take positions beyond their capabilities.( capacities?) We all buy many options in everyday life without being aware of it.. For instance, we reserve seats for travel. A reservation gives a right to occupy a particular seat on a bus or a train. What ever amount we pay in excess to reserve a seat is insurance premium for the assurance of a seat. If allowed, this reservation could be sold to others who are more needy and ready to pay more. Here we are transferring the right to travel. If no one travels on the date specified the money paid for reservation is lost. This clears two things. An option has a price and valid period

[wp_ad_camp_5]

In financial markets also there are many options. You may park your savings in a bank. You can buy shares. You can buy property. You can buy mutual fund units. You can buy government bonds. Each option has its own merits and demerits. Each has its pay off also. Thus options are not something related to financial markets only. They are part of our every day life. The only difference is that they are carefully analysed in financial markets.

Options are derivatives because they derive their value from some other asset. For example an airline buys an option to purchase a Boeing 747 at specified price after a year by paying 1 million dollars. The air line can sell this option for 2 million to another airline. Here the asset is Boeing 747. The option’s price is related to the value of the asset. This option can change hands many times before the actual delivery with each airline taking some profit on the sale. In the case of stocks too, there are options like these. For example, a person who wants to invest in stocks tells a seller that he would buy his stock only after a month and that too only shares that trade above a stipulated price. This is an unusual request. He selects a price of $20 for a share trading at 15 in the spot markets as his choice. In an exchange trading options, there may be many choices of prices fixed by the exchange. They are called strike prices. The stock selected may be trading at $25 at that time in the cash market or it may be trading at $15 on the particular day. Here the investor can choose his strike price. In such an exchange an option seller may agree to sell the share at $20 if the price remains above $20 on the expiration of the contract. Here the seller of the options takes some risks. He needs to hold his shares for a month and will sell them only if the price is above $20. If the price crashes, he will be holding his shares. This is a big risk He also takes another bigger risk. The share can go up to any extent, say $50 per share within the contract period and close at that price on the expiration date. The seller of the option then will have to sell the shares at $20 foregoing a huge profit of $30. Therefore an option seller will not write such a contract without proper reward. Like an insurance company he will estimate his likely losses and charge a premium on the risk he takes. This extra money demanded by the option seller is called Option Premium.

By paying this premium, the buyer gets a right to ‘call’ for the shares if they close above $20 at the end of the contract period. This right to ‘call for the asset’ is called a Call Option. If the price of the asset is below the strike price on which contract is made, the buyer of the option will not buy the asset. But the risk premium he paid to the seller will be lost. Thus the buyer of the Call Option gets the right to call the shares and loses a maximum of the premium he paid, if share price remains below the strike price on the last date. But the seller of the Call Option (parts missing) contracts on different rates.

Fixed strike prices increase the liquidity of contracts, making off setting trades easy. If a share is trading at $100 per share, the exchange trading the options on that share may fix strike prices 95.96.97.98.99.100.101.102.103.104 and 105. As the asset is trading at $100 in the spot market, a person buying an option at 95 strike price is trying to buy the asset at $5 discount. However the seller will take into account this factor also when he prices the option. These types of options are said to be ITM (In The Money). Here 95.96.97.98 and99 are in the money options. Options at 100 are ATM (At The Money) and options at strikes 101.102.103, 104 and 105 are OTM (Out of The Money).

As the seller of options bears big risks in case the share price moves up considerably, exchanges ask him to pay margins to avoid defaults. The margin is estimated by exchanges after assessing the risks related to his total positions at a point of time. Exchanges collects only option premium from buyers because it is the maximum amount of loss. It may seem that the seller is taking big risks. However, if he sells the option carefully estimating the maximum rise the asset can make, he can pocket the premium free. It is found that buyers of calls are usually losers. Sellers can also lose heavily if prices jump out of the seller’s estimates. Thus buying and selling of calls taken as a speculative activity is risky.

As the seller of options bears big risks in case the share price moves up considerably, exchanges ask him to pay margins to avoid defaults. The margin is estimated by exchanges after assessing the risks related to his total positions at a point of time. Exchanges collects only option premium from buyers because it is the maximum amount of loss. It may seem that the seller is taking big risks. However, if he sells the option carefully estimating the maximum rise the asset can make, he can pocket the premium free. It is found that buyers of calls are usually losers. Sellers can also lose heavily if prices jump out of the seller’s estimates. Thus buying and selling of calls taken as a speculative activity is risky.

TRADING CALL OPTIONS

BY now, it may be clear that a Call Option is a separate instrument derived out of the price of an asset. Therefore options become a tradable instrument. A call option on stocks is a right to buy stocks in future at a stipulated strike price. This right can be traded among option traders. For example, if an option trader buys a call option on MSFT at strike25 paying $2 premium, he can sell that option to others. If price of MSFT goes up, the value of his options too goes up. For example MSFT rises to $30. This means that a call at 25 strike price has an intrinsic value of $5 now. Therefore the premium on the call must reflect this increase in the asset price. A seller of 25 strike call at that price ($30) will ask for a $5 increase in option premium. Therefore prices of call options can go up or down depending on the stock prices. Our original buyer now sees the premium on the call he bought going above $5. He can sell that call at the higher price and take his profit. Speculators take this opportunity to make some quick money.

Suppose a speculator buys 1000MSFT call options at the strike price25 paying $2 premium when it is trading at $25 in the cash market. His total cost of options is $2000. If he wants to buy 1000 MSFT shares from the spot market he must pay $25000. If the share price goes to 30 after a few days and his call option has buyers at $6.75 he can sell his calls and take a profit of 6.75-2=4.75 per share. Then his profit will be 4750 before paying brokerage. In the cash market the buyer of MSFT pays 25000 and gets $5000 profit. The percentage profit in the option market is very high (4750/2000*100). This is a very attractive proposition for speculators. Therefore a large number of option traders buy and sell options assuming a likely (profitable?) direction.

However there is an opposite side to this story. The call options bought will have a contract expiration period. If the share price of MSFT does not move above $25 in the cash market, he can wait for the shares to move up for any number of months. It should be clearly understood that the option buyer assumes a directional movement on MSFT. He can be totally wrong. At each month of waiting, his capital is eroded and finally he may lose all his capital. Another problem for the buyer of call options is that the premium of the call is related to risks faced by the seller. The risk to the seller depends on volatility and time to expiration. As the time to expiration approaches, risk related to time goes down exponentially. If MSFT closes at $30 on expiration and our buyer of the call waits till the last date he receives just $5 from the exchange. The premium he has paid is lost. If MSFT remains at $25 he loses $2000.

Option prices are related to many variables. If MSFT is trading at $25 in the cash markets and calls at 25 strike price,( who?) receives $2 premium. A call at 20 strike price may have a premium in excess of $5 because the seller receives $25 even otherwise when he sells his share. $2 he paid for 25 strike call is purely time value. Similarly premiums on all the calls above 25 strike price consist only of time value. The risk faced by the seller on calls above 25 strike price goes on diminishing as the strike prices go up. This happens because the probability of out of the money call option reaching in the money is comparatively less. Thus premiums on calls depend on strike prices and spot prices.

Another factor that influences the option prices is the time to expiration. The probability of a call option reaching in the money increases if time to expiration of the contracts is more.

Volatility in the stock prices can affect option prices too. Volatility increases due to specific and systemic factors. Higher volatility increases risks for writing options. Therefore there will be increase in option premiums.

Interest rates also affect option premiums. Call premiums are seen to go up when interest rates in an economy increases The ratio between change in option price and change spot price is called delta of an option. At the money options have delta of 0.5. Deep in the money options have delta of one. Out of the money options have deltas less than 0.5 depending on how far they are from current spot price. It is found that delta is actually the probability of an option reaching in the money

To be continued

CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com