HISTORY OF OPTIONS:
Although options have existed for a long time, they wee traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the seventeenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firms would then attempt to find a seller or writer of the option either from its own clients of those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price.
This market however suffered form two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honor the contract. In 1973, Black, Merton and scholes invented the famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for option developed so rapidly that by early’ 80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.
Option made their first major mark in financial history during the tulip-bulb mania in seventeenth-century Holland. It was one of the most spectacular get rich quick binges in history. The first tulip was brought Into Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising. That was when options came into the picture. They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options. Later, however, options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. The writers of the put options also prospered as bulb prices spiraled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.
INTRODUCTION TO OPTIONS:
In this section, we look at the next derivative product to be traded on the NSE, namely options. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirement) to enter into a futures contracts, the purchase of an option requires as up-front payment.
DEFINITION:
Options are of two types- calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyers the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
PROPERTIES OF OPTION
Options have several unique properties that set them apart from other securities. The following are the properties of option:
Limited Loss
High leverages potential
Limited Life
PARTIES IN AN OPTION CONTRACT:
There are two participants in Option Contract.
Buyer/Holder/Owner of an Option:
The Buyer of an Option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer.
Seller/writer of an Option:
The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
TYPES OF OPTIONS:
The Options are classified into various types on the basis of various variables. The following are the various types of options.
1. On the basis of the underlying asset:
On the basis of the underlying asset the option are divided in to two types:
Index options:
These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled.
Stock options:
Stock Options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price.
2. On the basis of the market movements :
On the basis of the market movements the option are divided into two types. They are:
Call Option:
A call Option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. It is brought by an investor when he seems that the stock price moves upwards.
Put Option:
A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. It is bought by an investor when he seems that the stock price moves downwards.
3. On the basis of exercise of option:
On the basis of the exercise of the Option, the options are classified into two Categories.
American Option:
American options are options that can be exercised at any time up to the expiration date. Most exchange –traded options are American.
European Option:
European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart.
FACTORS AFFECTING THE PRICE OF AN OPTION:
The following are the various factors that affect the price of an option they are:
Stock Price:
The pay-off from a call option is an amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa.
Strike price:
In case of a call, as a strike price increases, the stock price has to make a larger upward move for the option to go in-the –money. Therefore, for a call, as the strike price increases option becomes less valuable and as strike price decreases, option become more valuable.
Time to expiration:
Both put and call American options become more valuable as a time to expiration increases.
Volatility:
The volatility of a stock price is measured of uncertain about future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. The value of both calls and puts therefore increases as volatility increase.
Risk- free interest rate:
The put option prices decline as the risk-free rate increases where as the price of call always increases as the risk-free interest rate increases.
Dividends:
Dividends have the effect of reducing the stock price on the X- dividend rate. This has a negative effect on the value of call options and a positive effect on the value of put options.
PRICING OPTIONS:
An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the price of an option.
There are various models which help us get close to the true price of an option. Most of these are variants of the celebrated Black- Scholes model for pricing European options. Today most calculators and spread-sheets come with a built-in Black- Scholes options pricing formula so to price options we don’t really need to memorize the formula. All we need to know is the variables that go into the model.
The Black-Scholes formulas for the price of European calls and puts on a non-dividend paying stock are:
Call option
CA = SN (d1) – Xe- rT N (d2)
Put Option
PA = Xe- rT N (- d2) – SN (- d1)
Where d1 = ln (S/X) + (r + v2/2) T
v√T
And d2 = d1 - v√T
Where
CA = VALUE OF CALL OPTION
PA = VALUE OF PUT OPTION
S = SPOT PRICE OF STOCK
N = NORMAL DISTRIBUTION
VARIANCE (V) = VOLATILITY
X = STRIKE PRICE
r = ANNUAL RISK FREE RETURN
T = CONTRACT CYCLE
e = 2.71828
r = ln (1 + r)
OPTIONS TERMINOLOGY:
Option price/premium:
Option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
Expiration date:
The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity.
Strike price:
The price specified in the option contract is known as the strike price or the exercise price.
In-the-money option:
An in-the-Money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price.
At-the-money option:
An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).
Out- of–the money option:
An out-of-the-money (OTM) option is an option that would lead to a negative cash flow it was exercised immediately. A call option on the index is out-of-the-the money when the current index stands at a level which is less than the strike price (i.e. spot price < style=""> If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price.
Intrinsic value of an option:
The option premium can be broken down into two components- intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero.
Time value of an option:
The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option’s time value, all else equal. At expiration, an option should have no time value.
| FUTURES | OPTIONS |
| 1. Exchange defines the product 2. Price is zero, strike price moves 3. Price is Zero 4. Linear payoff 5. Both long and short at risk | 1. Same as futures 3. Price is always positive 4. Nonlinear payoff 5. Only short at risk |
No comments:
Post a Comment