October 3, 2013

Options are the derivatives of underlying financial instruments. Underlying instruments or assets can be anything varying from commodity, interest rates, forward contracts, equities, etc.

We are going to talk mostly about options in regards to equities, how these are traded in Stock Markets around the globe and some of the risk management strategies which can be implemented while trading in equities and options.

**Functioning of options**

By buying an option, the buyer or owner gets the right to but not an obligation to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. Counter-party to the buyer is the seller of the option who has the obligation to execute the transaction if buyer opts to exercise the option.

In lieu of the right to exercise, the buyer pays a premium to the seller of the option. Most widely used options are “Call” and “Put”. Call gives the buyer the right to right to buy an underlying at a specified price, whereas Put confers the right to sell an underlying at a specified price to the buyer.

**Options are different from forward and futures**

Forward and future contracts have linear payoffs and do not require an initial outlay.

Options have non-linear payoffs thereby permitting their users to benefit from the movement of underlying in one direction and shield them from adverse movements.

However to profit from options one has to put in an initial outlay which helps a trader/investor to establish a position in the anticipated direction.

**Applications of Options**

Options can be put to mostly to two uses in the market:

**Speculation****Hedging**

**Speculation**

Speculation is betting on the anticipated movement in the market. The underlying can be either market index or a particular security. For instance, one can bet on movement of S&P 500 or on the movement of a single stock such as APPLE. Speculation can be in any direction, that is one can earn maximized returns not only when markets are bullish but also when they are bearish.

Speculation involves a substantial amount of risks because buying or selling of an option is a function not only of direction of the stock’s movement, but also the magnitude and the timing of this movement.

Options offer the speculators leverage apart from versatility. The initial layout is comparably far less to trade in options than stocks.

Dealers and traders also use options to earn profits. By implementing different strategies one can earn profit in stock markets using options only.

**Risk Management/Hedging**

Options can be used to immunize the investment from a downturn. It aims at minimizing the losses of investors and traders.

**Delta Hedging **

**“Delta” **is the change in premium (price of option) caused by a change in the price of the underlying security.

**Delta = Change in option Price**

**Change in Underlying Price**

Delta Hedging is risk management strategy that helps in reducing the risk associated with price movements in the underlying asset by offsetting long and short positions. Delta hedging of a long call is done by shorting the underlying stock. The relationship between the movements in underlying stock and option is the hedge ratio.

**Delta Hedge Ratio = 1/Delta**

For instance, a delta of 0.8 implies that for every $1 the underlying stock increases, the call option will increase by $0.80.

Put option delta are negative because while the underlying security increases, the value of the option will decrease. So a put option with a delta of -0.8 will decrease by $0.80 for every $1 the underlying increases in price.

Hedging strategies can be undoubtedly useful for large institutions as well as for the individual investor.

- To hedge the equity positions, equity dealers, traders, portfolio managers use options as the tool of hedging their equity positions. In this manner, they minimize their losses.

Let’s say an equity trader buys an IBM stock for $120. To hedge its position, he also buys a put for $5. If the stock moves against his expectations, the put will increase in price thereby restricting maximum losses to $5 which is the premium he pays to get the exercise option.

- It is used by companies and manufacturers to protect their cash flows and investments, and to protect their finances from adverse or sudden movements in interest rates.

**Volatility and Time**

Before getting into strategies to trade in options, one needs to understand that Value of the options is highly impacted by the Volatility of the underlying asset and the time remaining in the expiration of option contract.

We look at the volatility as the uncertainty or risk associated with the movement in an asset’s value. Volatility is commonly measured as standard deviation or variance from the mean return of the security. A higher volatility implies that range of dispersion is higher for security’s value or the price of security can vary sharply in a very short period of time. Lower volatility implies that price of security moves steadily. Higher Volatility implies higher risk.

Each Market has Volatility index to gauge how volatile the market is. **The Chicago Board Options Exchange Volatility Index reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes. 1st & 2nd month expirations are used until 8 days from expiration, then the 2nd and 3rd are used. High numbers mean that there is excessive bearishness, and low numbers indicate excess bullishness.**

**Volatility and the pricing of options:**

Price of the option consists of two components:

**Intrinsic Value**: It is the value by which option is in-the-money. Higher intrinsic value attracts higher premiums. If an option is at-the-money or out-of-money it has zero intrinsic value.**Time Value**: It is that part of the premium which is above intrinsic value. Longer the time until the expiry, greater is the value of option.

**Volatility impacts only “Time Value” of the options, not the intrinsic value**. As we go further out in time, there will be more time value in the option contract. Thus longer-term options will be more affected than the short term options.

Impact of volatility on the price of options is measured by a Greek Alphabet **“Vega”**.

Vega is the amount the call and put prices will change in theory for a corresponding one-point change in volatility. As volatility of the underlying increases, the value of options will increase as increase in volatility implies higher standard deviation and variance in stock prices.

Let’s say we have a 30-day option on stock XYZ with a $100 strike price and the stock exactly at $100 and Vega for this option is .05. Thus, for increase/decrease in volatility by one point, value of option will go up/down by $.05.

Keeping everything else constant, for a 120 day option on stock XYZ Vega can be as high as .20 which implies the value of the option change $.20 when volatility changes by a point.

**Effects of time on the value of options:**

Now, we look at the impact of time on the value of the option. Keeping the volatility constant, the time value of the option depends on two variables:

- Time remaining until expiration
- Closeness of the option strike price to the money, that is, whether the option is in-the-money, out-of-money or at-the-money.

Keeping underlying and volatility levels constant, the longer the time to expiration, the more value the option will have in the form of time value. Also, deep in-the-money options and deep out-of-the-money options have more intrinsic value and very little time value. Intrinsic value increases as the options get in-the-money.

Time value is at the highest level when option is at-the-money because the intrinsic value is zero at this point and has greater probability to rise.

**Impact of time on the value of the option is measured by Greek Alphabet “Theta”.** It is the decrease in the price of calls and puts for a one-day change in the time to expiration.

**Time decay, or theta,** is the biggest foe for the option buyer whereas option seller can benefit from the time decay of option value. Also time decay is accelerated as expiration approaches. As at-the-money options have most time value in its value, decay will be more significant over time than in- or out-of-the-money options with the same underlying stock and expiration date.

Thus, for an at-the-money 90-day option with a premium of $1.70, it will lose $.30 of its value in one month. A 60-day option, on the other hand, might lose $.40 of its value over the course of the following month. And the 30-day option will lose the entire remaining $1 of time value by expiration.

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