is an agreement (contract) between two parties that gives the buyer of the option the right and the seller of the option the obligation to buy or sell certain assets (securities, currency, etc.) at an agreed (fixed) price on an agreed date or during an agreed period.
Let’s consider, for example, stock options
. Stock options are contracts between two investors where one of them writes and grants the option and the other one buys it and acquires the right to either buy an agreed quantity of stocks from the option writer (call option) at an agreed price or sell them to that person (put option) before the option’s expiration time as specified in the term sheet.
Trading options entails limited risks both for buyers and for sellers. The buyer’s risk is limited to the premium he pays to the seller for the option. The seller’s risk is reduced by the amount of the premium (assuming that the option writer has to secure the option). Like futures options too are normally traded for two purposes: speculation and hedging.
There are two major option styles (or two approaches as to when an option can be exercised): European options and American options. European style
means that an option may only be exercised on expiration. American style
means that an option may be exercised at any moment on or before expiration.
Here we will look at American options as they are more popular and have better liquidity.
Call option — an option that gives the buyer of the option the right to buy a specified asset at a fixed price. In this case the writer of the option is obliged to fulfil the terms of the deal.
Put option — an option that gives the buyer of the option the right to sell a specified asset at a fixed price. As is the case with call options a put option also imposes on the writer of the option the obligation to fulfil the terms of the deal.
Expiration date — a date or period after which an option cannot be exercised.
Strike price — a fixed price of an asset the parties agree upon when making a deal.
Premium — price paid by the buyer for an option.
We will try to illustrate the parameters of an option by way of example:
CALL DJX 89 NOV 98
This line means that this is a call option, name of the asset (subject of the deal) — Dow Jones Industrial Average index (this designation is used on Chicago Board Options Exchange), Strike Price — 89, and Expiry Date — November 1998. The precise expiry date is not specified in this case, because all options traded on Chicago Board Options Exchange are executed on the third Friday of each month.
Speculating in options
Speculating in options means buying (selling) options just as any other type of securities. This instrument is attractive because:
– a speculator always knows the maximum amount he might lose,
– a premium one pays for an option is so small that profits may be unbelievably high if compared to the initial investment.
Consider the following example - Investor 1 has bought 1000 Microsoft stocks at USD 100 each (1,000x100 = USD 100,000). Investor 2 has bought 10 CALL MSFT 100 (1 month), having paid a premium of 1.5 points per option.
(1.5x10х100 = USD 1,500). After a month (on expiration date) the price of Microsoft stocks has reached USD 120.
Investor 1 gains USD 20,000 in profit or 240% per annum.
Investor 2 gains (120–100)*10*100–1,500 = USD 18,500 or 14 800 % per annum.
This example clearly shows that having invested a considerably smaller amount the buyer of the option earns almost as much as the stockholder.
Obviously, speculations in options entail huge risks (especially if compared to the risks assumed by stockholders).
Using the above example imagine that after a month the price of Microsoft stocks will remain at USD 100 or drop by USD 10. Investor 1 will lose USD 10,000 but he will still have 1,000 Microsoft stocks. While the value of the investment of Investor 2 will be 0 and he will have nothing valuable left (no stocks).
Main advantages of options
Return on investment in case of favourable trend considerably exceeds return on the same amount invested in stocks.
All other conditions being equal (the quantity of options and the quantity of stocks in particular) one needs to invest a much smaller amount.
A huge advantage of this highly speculative instrument is that maximum losses (unlike with futures) are limited to the invested amount.
Main drawbacks of options
The chief problem with options is that they have an expiration date. If the price of the underlying asset has not changed throughout the term of the option, the investor’s premium becomes zero.
Owners of options do not receive dividends even if the company in question pays them to its stockholders.
A relatively low liquidity of the options market. Naturally, everything here depends on the subject of an option: the higher the liquidity of the asset, the higher the liquidity of the option.
Large spreads up to 50%, which often hinders active trading.
Options are quite frequently used to hedge risks when buying or selling stocks. Because buying an option gives you the right to execute a deal with a certain asset at an agreed fixed price it can tangibly minimize risks and also serve as an additional source of income.
How is it done?
Consider the following example - An investor has bought 1000 Microsoft stocks at USD 100 each. Naturally, he wants to limit his risks in case the price of this company’s stocks goes down. In order to do that he buys put options with the same strike price. Normally, the price of a 1 month option of this kind will be approximately 1 point, i.e. in order to hedge his entire position the investor will have to buy 10 contracts, spending USD 1000.
Let us consider three different scenarios the market can possibly go through during that month to see the effect they will have on the investor’s portfolio.
Case 1. Price of Microsoft stocks remains unchanged. In this case the investor loses the USD 1000 he invested in the options, and his total portfolio is minus 1% (bought at USD 101,000.00, market price in a month’s time – USD 100,000.00 USD).
Case 2. Price of Microsoft stocks goes up 10% and reaches USD 110 per share after a month. In this case the investor loses the USD 1000 invested in the options, while the value of his portfolio is now USD 109,000,00. Which means that the investor earns 7,92% on the invested amount (USD 101,000,00).
Case 3. Price of Microsoft stocks goes down 10% stopping at USD 90 per share. In this case the investor will earn USD 9000 on his options and will receive USD 10,000 on expiration. The value of the stocks will be USD 90,000. Which means that the total value of the investor’s portfolio will be USD 100,000 or minus 1% instead of minus 10%, which would be the case if the investor didn’t hedge his position.
In just the same way investors can hedge reverse positions, i.e. when trade begins with selling stocks, not buying them. In which case call options are used instead of put options.
It should be mentioned that stockholders have a real opportunity to receive permanent income while their position remains open.
Let us return to the example with Microsoft stocks. An investor has an open position in 1000 stocks at USD 100 each. He writes a 2 months call option with the same strike price. The market price of such an option will be approximately 3 points. If the price remains unchanged throughout the term of the option, the investor will still have his position in stocks and a USD 3,000 premium for the option on expiration date. In which case return on the USD 100,000 invested in stocks will be 36% per annum.
In fact this trade will be equal to permanent income from investments. If you compare 36% per annum to 5% per annum (which an investor can earn by investing in fixed-income securities) this deal appears quite a handsome one. Certainly it also entails certain risks, such as the following ones:
By writing an option an investor undertakes an obligation to fulfil the terms of the deal, and if the price of Microsoft stocks goes up by more than 3 dollars, the party that bought the option might wish to exercise it. Thus, as a result of the trade the investor will have USD 103,000 where USD 3000 will be his profit.
A different scenario is also possible — when the price of stocks begins to drop. In that case an investor will receive a good premium, because the price of call options will begin to go down too. At the same time the value of the investor’s stocks will decrease. The main thing in this case is to take the right decision at the right moment.
Firstly, if the investor believes that this correction is temporary, he has a great opportunity to buy his option back at a lower price and thus get rid of his obligations.
Secondly, if the investor thinks that the trend has changed for the stocks he can close all his positions and if the maximum drop of stock price is 3 dollars it will be closing at a break-even point for the investor.
Please always be aware of and consider all risks associated with buying and selling options.
JSC „Rietumu Banka” accepts no responsibility for this information, which is provided for information purposes only. Any investment decisions that a client may take based on the information provided by JSC „Rietumu Banka” are his own decisions and in no event will JSC „Rietumu Banka” be liable for any claims or damages arising out of any decisions that a client may have taken based on the information provided by JSC „Rietumu Banka”.