Financial Concepts of Options and Option Strategies to Manage Risks

The Option Contract

The option contract can be a call option or put option. A call option gives the holder the right to purchase an asset for a specified price, called the exercise price or strike price, on or before specified expiration date. The holder of the option is not required to exercise the option. It will pay for the holder to exercise the call only if the market value of the asset to be purchased exceeds the purchase price. When the market price exceeds the strike price, the option holder may either sell the option or call away the asset for the exercise price and reap a profit. Other wise the option may be unexercised If not exercised a call option will become value less or will have any value. The purchase price of the call option is called a premium. Sellers of call options, who are said to write calls, receive premium income now as payment against the possibility they will be required to exercise the option at some later date to deliver the asset in return for an exchange price lower than the market value of an asset. If it is worthless then the seller will reap a profit equal to the premium if the asset price is lesser than the exercise price.

Say a call option which is a January 1995 option and its expiry date is 21st January 1995. Its exercise price is $70.00 and the call option sells at on13th of December 1994 for 2.375. Say on December 13th 1994 the stock sells for 69.625. If it remains below $70.00 the call will expire worthless. If this is the case the person who buys the call option on that date will loose 2.375, which is the premium he paid to purchase the call option. However, if its sells $75.00 on January 21st December 1995, the option will turn out to be profitable investment because it will give its holder the right to pay $70.00 for stock worth $75.00. The proceeds from exercise will be $75.00- 70.00. That is the proceeds = Stock price- Exercise price. However the profit = Proceeds – Premium = $5.00- 2.375 = 2.625. This is the financial essence the the process of put option trading.

As mentioned above option can also be a put option or a contract which enshrines the right to sell as opposes to right to buy at a specified time at a specified price. Say July put option on a stock with exercise price of $70.00 entitles its owner to sell the stock to the put writer at a price of $70.00 at any time before expiration in July even if the market price of the stock is less than $70.00. While the profits on call option increase when the asset increase in value, profits on put options increase when the asset value falls. That is, a put call will be exercised only if the exercise price is greater than the price of the underlying asset, if its holder deliver for the exercise price an asset with market value less than exercise price. (One doesn’t need to own the shares of the stock to exercise the stock put option. Upon, exercise, the investors broker purchases the necessary shares or stocks at the market price and immediately delivers or “puts them” to an option writer for the exercise price. The owner of the put profits by the difference between the exercise price and the market price.

For example consider a put option with a maturity in January 1995 with an exercise price of $70. The put is sold on December 13th 1994 for say $ 2.25. It entitles the owner of put to sell the stock for $70 at any time until January 1995. Say at the maturity date the stock price is say $68.00. However, if the stock rises above $70 then the option will become worthless at expiration date as the put option will not be exercised. That is if the stock price is greater then the exercise price the value of put option at expiry date is 0. In this instance the proceeds Option of put option = Exercise price – Stock Price = 70 -68 = 2. However, the investment cost is $2.25. There fore the Loss in this instance is 0.25. If the exercise of on option produces profits is described in financial terms as in the money and if it is a loss it is described as out of the money. When the asset value is equal to the exercise price of a stock or an asset then it is described in financial terms as at the money.

Option Trading

Options trade on over-the-counter markets. This offers the advantages in terms of exercise price, maturity date and number of shares committed. That is, the over-the-counter option trading offers the traders some tailored needs of their trading. However, the over-the-counter option trading establishment casts are higher compared to the exchange traded options. Today, most of the option trading occurs at established exchanges as well as on over-the counter trading in options. Options contracts traded in exchanges are standardized by allowable maturity dates. Mostly option trading in exchanges provides for the right to buy or sell 100 shares of stock (except when stock splits occur after the contract is listed and contract adjusted for the terms of the split).

Standardization of the terms of listed options means all market participants trade in a limited and uniform set of securities. This increase in depth of trading in any particular option, which lowers trading costs and results in more competitive market exchanges, there fore offer two important benefits: ease of trading, which flows from a central market place where sells and buyers and sellers or their representatives congregate: and a liquid secondary market where buyers and sellers of option can transact quickly and cheaply.

American and European Options

An American Option allows its holder to exercise the right to purchase (if a call) or (if a put) the underlying asset on or before the expiration date. European option allows for exercise of the option only on the expiration date. American options, because they allow more leeway than their European counterparts, generally will be more valuable. Virtually all traded options in the country are America if the exchanges are American Exchanges. However in US Foreign currency options and stock Index options traded in the Chicago Board option Exchanges are notable exceptions.

Adjustments to Option contract terms

As option convey the right to buy or sell shares at a certain price, stock splits may radically alter their value if the terms of the contract were not adjusted to account for the stock splits. Say for example a stock of a call option announces 10-for-1 split, its shares would fall a given value. If the option contract is not adjusted then the call option will become worthless because there is no possibility that the stock will sell more than the

exercise price. That is, the when stock splits happens the exercise price is reduced in proportion to the stock split. For example for a call option having an exercise price of $70, will be reduced if a 10 to 1 split occurs. The exercise price will be 10 new shares at an exercise price of $7. In addition, the exercise price is adjusted for any stock dividends, which is more than 10%. In this case the number of shares covered by each option is increased in proportion to the stock dividends, and the exercise price is reduced by that proportion. However cash dividends do not affect the terms of an option. This is because cash dividends reduce the price of stocks without inducing offsetting adjustments in the option contract. Value of an option is affected by dividends policy. Other things being equal, call option values are lower for high dividend policies because these policies reduce the rate of increase in stock prices. Conversely the put prices are higher for high dividend payout policies.

Option Clearing Corporation

Option Clearing Corporations are mainly play the role of clearing house. They are owned by the exchanges on which stock options are traded. Buyers and sellers of options will strike a deal who agrees on a price. The OCC steps at this point. That is all individuals deal with OCC when a price is struck. The OCC guarantees contract performance and not default.

Other Listed Options

Options do not only relate to stocks. Other options relate to market indexes such as S&P 500, foreign currency, futures prices of certain goods such as gold, silver, fixed income securities and stock indexes.

 

 Value of Option at Expiration

 

Call option

For call option, the option holder will only exercise his right if the stock price is more than the exercise price. However, if the stock prices are lower than the exercise price he will not exercise his right. That is if stock prices are lower compared to the call option exercise price the value at expiration is zero. That is the payoff of call option varies with the stock prices at expiration. For example if a call option holder has a call option with exercise price of  $70 and at the expiration the stock value is say $80 the call option holder can exercise the right to buy the option at $70 and sell the stocks at $80 and can make a profit of  $10. However, the option holder has to pay a premium. There fore, the net payoff is as follows:

Pay-off of call option = Stock price – exercise price- call option premium when stock price greater than exercise price. However, if the stock price is less than the exercise price the Pay-off = -call premium. That is, to make a profit the stock prices must rice at least by the amount of exercise price + stock premium.

For the call option writer the writer will have a value of Zero when the stock price is less than the exercise price as the call option holder has to pay a premium when he buys the option whether call option holder exercise or not. However, f the stock prices are higher compared to exercise price the writer will have a negative payoff. The profit for the writer is payoff + loss of payoff if stock prices are greater than the exercise price. That is like the call option holder the writer will break even when the stock price = exercise price + premium of call option.

Put Option

As opposed to call option, put option gives the holder the right to sell a stock at a given strike price at a particular point in time. The holder of a put option will not use his right to exercise to sell the stock at expiry date if the stock price is higher than the exercise price because the exercise price is lower than the stock price and if the holder of put exercises his right to sell he will suffer a loss. That is, if the stock price at expiry date is higher the option value will be zero. However, if the stock price is lower, then he will be at be earning a profit equal to the difference between the exercise price and the stock price at expiry date and the cost of put option.

The advantage of investing in option portfolios compared to investing in stock alone strategies

Say you have $7000 and have three strategies. The strategies are as follows:

Strategy A:  Purchase 100 shares of stock

Strategy B: Purchase 100 call options of stock with exercise price of $70

                   (10 option contracts, each for 100 shares)

Strategy C:  Purchase 100 call options each cost 7 for 700. Invest the reminder 6300 in T-Bills at 3% for the six month period of the call option expiry date.

The values of these portfolios in six months are as follows:

                                                            Stock Price

Portfolio           50        60        70        80        90

All Stock          5000    6000    7000    8000    9000

All options        0          0          0        10000  20000

Call and

T-Bills              6489    6489    6489    7489    8489

Note in all these strategies the initial investment is 7000. Based on the value of these strategies at various stock prices the rates of return can be as follows:

                                                            Stock Puces

Portfolio           50            60       70          80         90

All stock           -28.6%   -14.3%   0.0         14.3%     28.6%

All options     -100.0% -100.0% -100.0%   43.3%    185.7% 

Call and

T-Bills               -7.3%      -7.3%     -7.3%     7.0%      21.3%

One can see from the above rates of return the stock portfolio and call option alone portfolio more favorably when the stock prices are increasing from the strike price or the exercise price of the call option. As well, one can see the call option strategy has very high return compared to stock investment if the investor likes to speculate. However, if the stock prices are lower than the strike price or the stock prices tend to reduce I the future the call option and t-bills strategy has the most favorable return compared to stock and call option strategy. That is options as demonstrated above have the capacity to hedge against downward risk in price movement and minimize risk or limit losses compared to stock or option strategies. That is given the investors risk profile options can make appropriate portfolios in different ways to manage risks and hedge against risks. As well, it is also an instrument for speculative purposes. As explained above this is one reason to include options in a investment portfolio. This also demonstrates the versatility of options to tailor make an investment strategy to satisfy the risk and return preferences of an investor.

Conclusion

As explained above stock options and other options are very important financial instruments for an investor and other institutional investors. It is a versatile instrument and it is a vital financial strategy in the hands of a professional financial controller to hedge against risk. That is options play a vital role in maximizing returns and minimizing risks. As well, it can also be used for speculative purposes by investors. In addition, it is also an important financial instrument for fund managers to create appropriate investment portfolios so that it can satisfy the preferences of risks and return expected by their clients. However, if it is not used wisely it can also increase the risks and one must be careful in using options to hedge risks and must use other financial instruments like futures and swaps to manage risks because they are more appropriate to manage certain risks most effectively than options. In other words options ins very complex fashion can be used if constructed properly can be a useful tool to manage risks and hedge risks adequately.