Anything that has to do with investments will be subjected to risk and return. Normally, the higher the risk the higher will be the return. Is there any investment that will provide you the opposite, where the potential risk is reduced while the return will actually increased?
The answer is YES and it is through Options. Options beauty about options is it offers limited downside through premium and unlimited upside potential through profits. Another thing about options is that it enables you to play the market both ways and that is up or down. By buying a put option, you are hoping to for the price of underlying securities to go down. However, if the price of the security goes up, your losses will only be capped by the premium.
Hence it will give you sleepless nights. The thought of investing in Options actually terrified most people because to them anything that sounds sophisticated must be very risky.
Can is a stock option? A stock option gives the right to the to the owner to buy or sell a listed stock at an agreed upon price and an agreed future date. Stock options are contracts that consist of shares of a particular stock.
One party is the buyer of the contract and the other is the seller of the contract. During the duration of one year, the price of the piece of land may fluctuate. The purchaser of the agreement will have two options whereby. A put gives the holder the right to sell a specific number of shares normally in shares lot at a fixed price and date in the future.
A purchaser of a Put option is hoping for the stock price to go down. Say an investor purchase the above option. A call gives the holder the holder the right to buy a specific number of shares at a fixed price and date in the future.
A purchaser of Call option is hoping for the stock price to go up. Factors affecting Options Pricing. The following table shows a typical listing of an option data. Below is a description of the above table. Total amount of contracts that have been open but not offset. Five Factors affecting option pricing. Basically there are five factors that are affecting the options pricing and they are. The current stock price and strike price. If you have purchase the below Call optionthe amount of profit is determined by affect amount in which the Stock price exceed the exercise price.
Therefore, the Call option will be more valuable if the Stock price is increasing and less valuable if the Exercise price is increasing. Put options behave exactly the opposite of Call options.
If you have purchase the below Put option, the amount of profit is determined by the amount in which the Exercise price exceed the Stock Price.
The difference is the profit. Therefore, the Put option will be more valuable if the Stock price is decreasing and less valuable if the Exercise price is increasing because profit is equivalent to Exercise price — Stock Price.
The Delta value indicates how much the Option price will move in response to a movement in the Stock price. If an option with a Delta value of 0. As you can see from the above chart, the longer the time to expiry, the more valuable will be the option. Hence, an option with days left to expiry will be more valuable than an option that has only 30 days to expiry. The holder of a days to expiry option has more exercise opportunities than a holder of 30 days to maturity option.
The nearer to expiration date, the higher the Theta value and vice versa. A theta value of So for the duration of a week, the option will lose a total of 14 cents because both Saturday and Sunday will also be included in the calculation even though there is no trading during those days. The Volatility of a Stock is measured by the Standard Deviation of the return provided by the stock in a year and normally express in percentage terms.
In other words the volatility of a stock price is a measure of how uncertain we are about the future movement of its price. As volatility increases the profit or loss of a particular stock also increases due to the wild swings of the stock price. How does this affect an options investor? If a stock price increases, it will benefit the owner of a Call option while at the same time it will be detriment to the owner of a Put option. Similarly, if a stock price decreases in its value, options will benefit the owner of a Put option and it will be detriment to the owner of a Call option.
If Vega is high then the stock option is very sensitive to changes to Volatility. Changes Vega value is determine by the changes in the volatility, which is expressed by every 1 percentage point. Suppose we have the following scenario. Movement in interest rates affects the stock price and hence the options price as well.
Whenever there is an increase in price interest rate, stock prices tend to fall. A fall in stock prices will have detrimental effect to Call options. Holders of Call options will certainly lose out because if the exercise price is lower than the stock price then they will suffer losses. Holder of Put options will stand to gain when stock price decreases because their exercise price will be higher than the stock price. If an option has a Rho value of 0. Cash Dividends, Stock Dividends and Stock Splits.
When a corporation declares a dividend, it establishes a record date. This record date will be used to record the owners of the stock on that date so that they will be entitled to the dividend.
Since a normal transaction in the security industry requires 5 working days to complete, naturally the transaction need to be carried out 5 days before the record date.
Cash Dividends have the effect of reducing the price of the stock on the ex-date. The stock price will go down in relation to the amount of dividend declared. This will invariably have effect on the Option price. For those who bought Call options, this will be bad news as the price of the option will also had to be calibrate downwards so as to reflect the changes in the stock price. Whereas for those who bought Put options, then it will be good news to them as the decrease in the stock price will add up to their profits.
Since by buying a Put option, you are hoping for the underlying stock price to go down. Stock Dividends or Bonus Issue will greatly affect the terms of the options contract. What happened next is that each shareholder will receive extra 50 share for every they owned. The amount of shares is also adjusted in this case from shares to due the extra 50 shares from the dividend. But then the price of the share will also need to be stock to reflect the additional new shares.
This exercise, can be shown by the following. Stock Splits will also works the same, with adjustment to the number of Shares and its price. There are various strategies that can be employed using options to counter different market conditions. Equity Options can be used as a hedge and also speculate on the underlying securities.
For example if an investor thinks that underlying security is getting bearish in the coming weeks. He can counter the downturn with the following moves. However there are more complex strategies that are available in trading options and it is not suitable for many investors. A Straddle is made up of one put and one call option on one underlying security that is having the same strike price and expiry.
So in a straddle, the investor buys or sells two identical options except one is put and the other is call. The investor can either have a long or short straddle. After studying the volume accumulation of IBM and its price patterns, price investor feels that IBM is going to make a move but not sure whether up or down.
What she can do is the following. By this, it means that she will be participating in either an upward or downward movement of IBM. So the beauty about this strategy is that if the IBM stock goes above or belowthen it will start generating a profit. However, the investor seldom loses all of the premium because the investor can cut loss in between. Instead of paying for the premium, an investor who sells an option receives the premium. However the risk and reward for the investor who sells a straddle is different from the person who buys a straddle.
In other words she is selling writing in option lingo an uncovered call in this case. So by selling a straddle, she will be exposed to limited profits but unlimited losses. If you are not familiar with options, it will better limit yourself, to buying and not selling options because the risk is too high. If the investor feels that the market direction is bearish for IBM, instead of buying a straddle she can buy a strip. A strip consists of 2 puts and one call. An example will be the following.
So if IBM were to go down, the investor will have a bigger profit. Say if IBM dropped tothen there will be a profit of 40 points 2 put options x 20 points.
It will be a different story if the stock price rose. The investor need at lease a 24 points gain in IBM stock to cover its premium so that she will be break even. In other words, IBM stock will need to rise to at least so that so can exercise her call at and sell the stock at If the investor feels that the market direction is bullish for IBM, instead of buying a straddle she can buy a strap.
A strap consists of 2 puts and one call. So if IBM were to go up, the investor will have a bigger profit. The effect will be the opposite of our strip strategy earlier. These are different forms of straddle but varying the degree of puts and calls by capitalizing on the market condition whether it is bullish or bearish. A combination will be an event where the underlying stock is the same but the strike price or the expiration date is different. An example of a straddle with a different strike price is shown below.
As you can see, the strike price for the call iswhereas the put is To achieve a break even, the stock price had to be at least for the call option or for the put option. However, this is a highly unlikely scenario. In this case, the strike price is the same atbut the expiry date is different.
Call on August and Put on September. The extra month of expiry of the Put will raise the premium to 9. In this case the extra risk involve will be the extra month for the Put to expiry. If it is let uncovered, what happen when the stock price go up to in September?
The investor will have to bear the losses of 50 points So the potential losses in this case will be unlimited. There are other more sophisticated strategies, which I think should reserve for professional options traders.
Some of them are dealing in more than 3 options at one time. An example will be the butterfly spreads whereby it involves buying 1 low price call option, 1 higher price call option and selling 2 call options with a price in between the buy call options. It can be illustrated below. Buy 1 IBM Aug Call - Premium Sell 2 IBM Aug Call - Premium 9. In this case an investor will only make a profit if the stock price is trading in between and So if the stock price, move out of this range, then the maximum the investor can lose is 4 points.
Other strategies include the following. Alright, that basically sums up our Trading Strategies and next we will look into how Big Money and Insiders manipulate the Stock Market using Options. The stock market has always been in the influence of Big Money and Insiders. Most of the trades and volumes, generated in most stock exchanges around the world, are done by either by quantitative or high frequency traders. However, there is one tool that escapes the attention of most traders or rather amateurs that professionals use, not only to reduce risk but also to influence trades in stock markets.
The tool that they employ is Equity Options. How they use it to their advantage? Block trading refers to the buying and selling of large number of shares in a particular security.
It normally refers to hundreds of thousands or probably millions of shares and they are common in the security industry. That is why some brokers have a special department just to handle such trades because it is very profitable. Their investor is not interested in staggered sales or selling by small amounts, which may take up to two months to dispose. Getting another investor to take up the affect is not easy. Say if they found someone who is interested in only buyingshares, so what is MS going to do with the remainingshares?
In this case, MS will incur a loss on itself, which is not a good strategy. Option B will be a better strategy and MS may execute the following. So, what the above strategy does is Sell IBM Call Options, which is, shares x shares and in this case there is no risk because MS had already in possession ofIBM shares from the investor. But in this case, there is a downside risk associated with selling a call option.
Option C will be to buy a put option on IBM, which can be illustrated below. But professionals are different from amateurs because they will rather take a risk and make a profit than to just receive a commission for doing the trade.
So, professionals will rather go for Option B rather than the rest because it is their job to manage risk. Amateurs probably, will be better of by buying the put and pay the premium, because their risks are protected.
Investors may use options to disguise their activities in the stock markets. If they are interested to acquire a large position in a company AB say 1 million shares, they may do so in the following methods. The investors will need to buy all of its 1 million shares in the open market. By purchasing such a large amount of shares, will lead to an appreciation in the price of the target company. Moreover, by buying such a large block in the open market will tend to arouse attention among other investors because it will increase its volume.
Hence this will induce other investors to participate into buying the shares and will push up the price of the shares of the targeted company. This will make this exercise very expensive and difficult and hence is not a good strategy.
Option B will be a better strategy and the investors may execute the following. In options case, he can buy the shares in the stock exchange without arousing any attention to his activities. He can slowly take his time to accumulate his shares quietly in the stock market while at the same time he purchase AB Aug Call options. Hence, the use of options helped the investors to accumulate their required amount of shares in a particular company, without arousing much attention of other investors, which might make it difficult for them to achieve their goal.
Company Directors, Financial Controllers and Insiders, may use options to hide their activities in the stock markets. If they are in the know that there are good news pertaining to their company such as a larger than expected profit, a Merger or Acquisition activity, a large find of mineral reserve and etc.
Instead of buying or accumulating of shares of their company in the open market, they may buy call options of their company. When the good news is reported, they can cash in their call options.
But they might be under the scrutiny of the Securities Commission, as call options is also known as stock equivalents.
Since call options can be converted to shares, they may be subjected to insider trading. However, they can get around it by purchasing it under someone else name such as their relatives or some sort. Similarly, this also applies when Insiders may use options to capitalize on the bad news of their company. If they know that their company will be reporting a larger than expected loss or the canceling of a Merger and Acquisition agreement, they can buy a Put Option.
So when the bad news is announced, the price of the underlying security will go down and hence the price of options. So they just exercise their put option for a profit. Due to the diverse amount of shareholders, the ownership of some companies are rather thinly distributed.
These companies are prime target for hostile or management takeovers. They can do it through the options market without arousing the stock of the management. By the time they have accumulated enough options, they can exercise it and they will automatically become a substantial shareholder. When they have gain control of the company, then can blackmail the current management by threatening to discharge the whole management. So in order not lose their jobs and the perks that come with it, management had to conformed to their demand by buying back their shares at a higher price.
Again, investors can get around it by purchasing the stake with different names. If an investor is holding a block ofunits ABC shares, which only trades about shares a day.
How can he get rid of his shares in a short time period of say one week? Should he dispose the whole block of ABC shares in the open market, it will crash the share price of ABC. What strategy should the investor employ to sell the shares without hurting its share price? By buying the put it will cost him a 2 points premium. Always remember you will receive the premium when you sell an option and vice versa. So, finally as you can see, there are many affect of options, not only to trade but also to maneuver your trading strategies in the market.
Another use of options can to help Multinational Corporations to hedge their risk in their global operations. This will require another article, which I will later address on how Multinational Corporations use Currency Options, Forward Contracts and Currency Swaps to hedge their foreign exchange exposure in international markets. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice.
Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis.
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