Free «Option as a Financial Instrument» Essay

Definition of an Option and Contract Parties          

Option is a contract signed between the two parties, in accordance with which, one person gives another person the right to buy or sell a particular asset at a predetermined price within a certain period of time. Options are a powerful and flexible tool to use in a variety of trading strategies (Söderlind & Svensson 1997). At the same time, one should be aware that options are a complicated instrument. The first danger is the short sale option contracts because they can result in unlimited losses. Usually, during the year, 4 months of contracts expiration are appointed (Hull 2006). They are set consecutively with an interval of three months. Date of contracts expiry is usually Saturday following the third Friday of the expiration month of the contracts (Saunders, Cornett & McGraw 2006). Various transactions with options can be initiated both in the interests of the underlying assets, and in the interests of the options as an independent object of trading activity. Customers engaged in transactions in options are divided into hedgers and speculators.

The responsibilities of the buyer of an option include timely payment of premiums, and the responsibility of the subscriber option is the provision to the clearinghouse (clearing) strict certain guarantees to fulfill its obligations (margin) in the form of a pledge of money or securities (Cox & Ross 1976). It is typically approximately 20% of the gross market value of the underlying assets. Margin for the subscriber purchase option is 20 percent of the market value of the underlying asset minus the difference between the strike price and the current market price of the underlying asset (Boukendour & Bah 2001). Margin for the subscriber of the option equals 20 percent of the market value of the underlying asset, plus the difference between the strike price and the current market price of the underlying asset. The magnitude of the margin should not be less than 3% of the market value of the underlying asset (Hull 2006). The fee clients of the brokerage firms who pay for the purchase or sale of option contracts are not recorded in the specification of option contracts and are determined on the basis of the agreement.

Option Holder. Option holder is a party in the option transaction, which pays premium to the seller and has the right but not the obligation to buy (call option) or sell (put option) the underlying asset at a fixed price (Saunders, Cornett & McGraw 2006).

Option Writer. Option writer is a party in the option transaction, who receives financial bonus from the buyer, but who assumes the obligation to deliver the underlying asset at a fixed price.

There are many types of options: the option to buy (option "call"), an option to sell (option "put"), double option (option "straddle"), option "butterfly”, etc. Each of such options is called to solve their specific problems (Söderlind & Svensson 1997). But all option types have one common feature: in fact, for buyers the options, on the one hand, are the insurance mechanism of adverse events (primarily fall or rise in the market value of the asset), and on the other hand, the buyers of options acquire opportunities for growth. As for option sellers, their motive is the hope for non-occurrence of favorable outcomes for customers, when the latter will not exercise the option or at least hope that the resulting profits outweigh the amount paid on liabilities.

The specifications of options contracts may include the following information: style of the option; unit of trading; month expiration of the contract; expiry date of the contract; day of the delivery or settlement; the date of execution; last trading day; factor; way of the quotes on option prices; the minimum price fluctuation; settlement price in the performance; intervals exercise price; way of introducing new exercise prices; method of payment of premium subscriber; trading hours; way of the option; margin calculation subscriber; limitation (Kim, Kim & Kim 2004).

Today, many options are traded on foreign exchanges. In addition to forward transactions for the purchase or sale of ordinary shares there are option contracts on stock indices, bonds, commodities and foreign exchange. Currently in the US options are traded on six stock exchanges:

American Stock Exchange

Chicago Mercantile Exchange

Philadelphia Stock Exchange

Chicago Board Options Exchange

Pacific Stock Exchange

New York Stock Exchange

In Europe, the most popular exchange for options trading is LIFFE - London International Financial Futures and Options Exchange (Hull 2006).

Types of Options

Options "call" and "put". There are options of two types: options, which give the right to buy - purchase options (call options) and options that give the right to sell - selling options (put options). Option call gives its owner the right to buy shares (or any other asset) at a special price, called the exercise price or the price of the transaction ("strike" price) (Boukendour & Bah 2001). In some cases, the option can be implemented only in one particular day (Boukendour & Bah 2001). Such option is called European. In other cases, the option can be implemented either within a set day or for some period before it, and such option is called American call.

For simplicity of understanding, here is an example of the European call with an exercise price of 100 USD. If the share price at that time is below such value, no one will pay 100 USD in order to receive shares via the option call. In such case the option call is devalued and it is not used at all. On the other hand, if the stock price is above 100 USD, it will give the opportunity to exercise the right to buy shares. In such case, the option value will be equal to the market price of shares, net of 100 USD that has to be paid in order to purchase the option. Option "put" gives the holder the right to sell shares (or other asset) at the exercise price. In the above example with an exercise price of 100 USD option will not be worthless if the stock price at the time of execution is above the exercise price, and will cost (in the amount of the difference between the exercise price and the market price), if the share price falls below the exercise price.

Stock options. Stock options provide for the purchase or sale of a certain number of listed shares (usually 100 or 1000 pieces) on a fixed contract price (Hall & Murphy 2003). The aggregate exercise price and the aggregate premium of an option contract are obtained by multiplying the exercise price of the award and the number of shares in the contract. Stock options are mostly American-style options with physical delivery (Dennis & Mayhew 2002). Owners of shares serve different purposes by selling call options: reception of an award, while the option subscribers continue to receive dividends on the shares. Entered contracts very often offer insurance from large fluctuations in their stock portfolio. Covered subscribers of call options are entitled to receive dividends on the underlying share until the option is exercised. However, the option holder has the right to receive dividends, if she/he exercised the option before the date of registration of shareholders, even if the subscriber is assigned to the option was notified of the option is exercised after the date of registration (Hall & Murphy 2003). Exercising of the American-style option selling before the date of registration of shareholders, after which the observed fall in the price of the underlying shares is experienced, is a profitable strategy for the option holder.

Options on stock indices. Index options are usually used as a hedging instrument is widely diversified stock portfolio from the risk of falling market value (Ratanapakorn & Sharma 2002). All index options are cash-settled options and can be both American-style and European. In the execution of an index option and purchase of the positive difference between the value of the index and the exercise price of the option, and for the call option - between the exercise price and the value of the index, is multiplied by a factor specified in the contract specifications. Thus, calculated amount is paid in cash to the holder of the option. The aggregate exercise price and the aggregate premium index are obtained by multiplying the option exercise price and the premium on the multiplier option (Merton 1998). Estimated exercise price for index options is based on the average level of the index for a short period of time beginning from the last trading day of the option (Ratanapakorn & Sharma 2002). When calculating the fair value of an index option it is assumed that it can be represented as a share with a certain rate of dividend.

Currency options. Currency option provides the option buyer with the right to buy or sell foreign currency on a specified date or within a certain time at a fixed rate (Carr & Wu 2007). Currency, in which the premium is realized, is called currency trade, and the currency that is bought or sold is called the base currency (Merton 1998). Between currency options and stock options there are some differences, particularly in regards to the establishment of the fair value of the option. Most currency options currently involve physical delivery of the base currency, but there are currency cash-settled options in units of currency trading, for example, on the Philadelphia Stock Exchange (Carr & Wu 2007). Currency options exist both in American-style and in European. The ratio between the value of the base currency and the amount of the option premium is expressed as follows: if the value of the base currency against currency trading increases, the option premium usually raises purchase and sale of an option is reduced. To determine the aggregate exercise price and the aggregate premium of an option contract, the exercise price and premium must be multiplied by the unit of trading.

Options on short-term bills and long-term bonds. The price of any bonds directly depends on the level of the existing banking market interest rates. Therefore, option contracts on bonds are made with the assumption to catch a favorable change in the bank interest rate; or vice versa, to hedge against unfavorable changes in it. At the option exercise price quote on long-term bonds may be used as a full price of a bond with the coupon payment and the net price of bonds without it (Bakshi, Cao, & Chen 2000). All options on short-term bills and long-term bonds are European-style options, cash-settled and are based on profitability. It means that at the expiration of the contract with the holder of the option is calculated in cash based on the difference between the value of the base index of profitability and the exercise price of the option (Campbell & Viceira 2002). The index base yield is the annual yield to maturity of the bond and with the specified maturity multiplied by 10 (Bakshi, Cao, & Chen 2000). Treasury bill index calculation is based on annual yield using the discount interest rate bills on time of the next release. When one exercises the CBOE option based on profitability, its estimated exercise price is calculated based on the yield to maturity of the bond base, designated Federal Reserve Bank of New York at 2.30 on the last trading day of the contract (Campbell & Viceira 2002). The total premium of the option contract is equal to the quoted premium multiplied by the multiplier option. Complete estimated amount in the exercise of the option is equal to the difference between the settlement price and the performance of a fixed contract price, the multiplication factor for the option.

Options on futures contracts. The unit of trading options on futures contract is a futures contract with a specified delivery month and with a certain underlying asset. All options on futures contracts are American-style options. Options that expire "in the money" are automatically executed according to the instructions of the clearinghouse (Hull 2006). In options on futures contracts exercise prices are traded in the futures price points. The term of the basis futures contracts usually ends shortly after the expiry date of the option contract. The holder of the purchase option on a futures contract in the exercise of an option opens a long position in a futures contract and receives an amount of money equal to the excess of the futures price over the exercise price. At the same time, the call option holder receives the short one and the amount of money equal to the excess of the exercise price of the futures price. One should note that, unlike the others, options on futures contracts during the purchase of the option premium subscriber may not be paid and the payments both for the holder of the option and the writer can be made after the execution of the option holder (Hull 2006). In determining the fair value of the option futures contract is treated as share dividends are paid, the rate of which is equal to the risk-free interest rate. The amount of bonus options on futures contracts depends on the ratio between the price of the underlying futures and the exercise price (Lien & Tse, 2000). The growing popularity of trading options on futures contracts is caused by a number of reasons: flexibility – for options on futures it is possible to take an accurate market position allowed by the relevant investor risk and profit potential; lack of commitment - an option gives the right to choose without obligation to buy or sell a futures contract; limited risk - the maximum risk of the holder of the option reduced the risk of losing the premium; lack of margin requirements for the buyer of the option, despite the fact that the participants of the futures transactions from both sides have to pay margin; the ability to sell an asset by reducing its cost, because the option holder receives no margin requirements while reducing the cost of basic bonds; high liquidity in the options market makes it easy to open and close positions (Lien & Tse, 2000).

Transactions in Options

In all cases, when a company makes a loan, it creates an option, because one cannot force the borrower to repay the debt at the end of the agreed term of the loan (Kim, Kim & Kim 2004). If the value of the company's assets is less than the debt, the company chooses not to fulfill its obligations (as would be insolvent) and bondholders will receive their assets (Hall & Murphy 2003). Thus, when a company makes a loan, the lender, in fact, acquires the assets of the company and the shareholders receive an option to repurchase them through debt.

Using the options one can simulate a variety of financial flows: an option to continued investment, if the investment project is successful; the option to reject the project; an option to wait and select an optimal time to invest in the project. While in cases when it is not possible to determine uniquely a single discount rate for the entire period of investment (for example, it is subject to strong fluctuations), the use of option pricing mechanism is more accurately compared with the method of net discounted cash flows (NPV-test) (Portes, Rey & Oh 2001).

In the absence of exchange-traded option contracts, they can conclude them on a bilateral basis between the companies, for example, forward contracts. In addition, option contracts themselves can create (model) within a company using the acquisition of assets loans and use the "short" sales of assets (Kim, Kim & Kim 2004). Moreover, options, like futures, can be used without the delivery end of the asset. To do it, one should first open position of the purchase or sale of any option and then the position may be closed with the opposite transaction - sale or purchase.

Possible Options Strategies

A synthetic option put is created (using the stocks and bonds), and knowing its price (prize), an attempt can be made for selling it on the market at a higher price. In such case, one can try to, first, find a buyer for the option (with the already overpriced) and immediately after that purchase a protective put (stocks and bonds). In addition, an opposite approach is possible: knowing the price of a synthetic put, buy it in the market in the form of an option contract with cheaper prices. Then one of two things can be done: either resell it in the market with a higher exercise price or, in case of impossibility of a more profitable resale, wait for execution.

One can calculate the parameters of synthetic call (through the purchase of shares and the loan of money) and knowing the combination of its price (and performance bonuses), attempt to purchase such call cheaper in the market or sale it for higher price. One can still have pure arbitrage (first sell more, then buy cheaper, or vice versa first buy cheaper and then sell more expensive).

Conclusion

Options are used to extract profits from speculative transactions and to hedge risks. They allow an investor to limit the risk of financial loss with only a certain amount that she/he pays for the option (Cox & Ross 1976). At the same time, the profits can be of any amount. It distinguishes options from futures, where, regardless of the fact whether assumptions regarding the investor market conditions are justified, he is obliged to make a deal on the terms agreed in the stipulated day. Options are risky type of investment, but their advantage is that the risk is known in advance: the investor risks losing only the price of the option. Due to such feature, the options are very popular among speculators (who bring liquidity to the market), and investors will receive a flexible tool for building complex trading strategies.