Академический Документы
Профессиональный Документы
Культура Документы
This article introduces the concept of derivatives and explains their utility. It also explains futures and options in detail.
What is a derivative?
The textbook definition of a derivative is: A derivative is an instrument whose value depends on an underlying.
What does it mean in simple terms? Well, the word is kind of self explanatory the value of a derivative
is derived from the value of something. This something is called the Underlying of the derivative.
So, for stock derivatives, the price of the shares of a particular company is the underlying. For an index derivative, the
value of the index is the underlying. And for a crude oil derivative, the price of crude oil is the underlying.
As and when the price of the underlying changes, the value of the derivative based on it also changes. Of course, the
price also depends on the demand and supply for that derivative, but the primary driver of the price of a derivative is
the price of the underlying.
Types of Derivatives
There are many types of derivatives, but let me talk about the two basic derivatives traded in India.
Futures
This is a derivative contract in which the quantity, rate and date of a future purchase is agreed upon today for a given
asset.
At this pre-decided date, the buyer of the futures contract gets the delivery of the pre-decided quantity of the given
asset at the pre-decided price. Similarly, the seller of the futures contract gives the delivery of the pre-decided quantity
of the given asset at the pre-decided price.
In a futures contract, both the buyer and seller are bound to honour their commitment the buyer has to take delivery,
and the seller has to make delivery according to the terms of the contract.
Thus, even if the price of the asset goes down, the buyer has to get the asset from the seller at the pre-decided price.
And even if the price goes up, the seller has to give the seller at the pre-decided price.
Cost
There is no upfront cost involved in the purchase of a futures contract, apart from brokerage.
Example
A sells the futures contract of Reliance Industries stock to B. Quantity is 200 shares, price is Rs. 3200 and the expiry
date is 3 months away.
Now, after 3 months, irrespective of the market price of the stock of Reliance Industries, A would deliver 200 shares of
Reliance Industries to B at Rs. 3200.
Options
As the name suggests, here, the buyer has an option to take delivery of the asset, and not the obligation. Thus, if the
market price of the asset goes up, and buyer of an option would exercise the option and get profits. But if the market
price of the asset goes down, the buyer of the option would not exercise it, and would allow the option to lapse.
Thus, Options are more flexible for the buyers compared to futures. But the seller of the option has the obligation to
deliver the assets if the buyer chooses to exercise the option.
In case of options, the pre-decided price for the exchange of asset is called the Strike Price.
One thing to remember though is that in reality, not many people actually exercise their options people do not
actually exchange the asset at the time of exercise. Since the options are traded in the market, instead of exercising
them, the buyers just sell them in the market.
The logic behind this when an option is in the money (that is, when it becomes profitable for the buyer), its option
premium or the price goes up. So, one can sell it and make profit instead of exercising it. This is easier, and therefore
is done by most people.
American and European Options
The options are of two types American and European. In American options, the option can be exercised any time
upto the settlement date. In European options, the option can be exercised only on the settlement date. Thus,
American options are much more flexible (I am introducing this here just as a concept in India, only American
options are traded).
Cost
There is a cost involved for options the buyer of the option has to pay the seller an Option Premium, which is the
fee the option seller (also called the Option Writer) gets in return for the one-sided guarantee he extends to the buyer.
Since the option writer assumes the risk of the price movement, this fee is well justified.
Example
A writes the option of Reliance Industries stock to B. Quantity is 200 shares, strike price is Rs. 3200 and the expiry
date is 3 months away. The option premium is Rs. 25.
Now, during these 3 months, say the price of Reliance Industries stock goes up to Rs. 3400. In this case, B would
exercise the option, and would get the shares at Rs. 3200 from A.
Thus, B would make a profit of Rs. 3400 Rs. 3200 Rs. 25 (Option premium) = Rs. 175. Similarly, A would make a
loss of Rs. 175.
But if the price of Reliance Industries stock remains less than Rs. 3200 for the 3 month duration, B would not exercise
the option. In this case, the option buyer B would make a loss equal to the option premium Rs. 25 in this case, and
the option writer would make a profit equal to the option premium Rs. 25.
Use of Derivatives
The primary use of a derivative is to hedge risk (also called Hedging). When you buy a derivative, you are making a
provision that makes your cash flows more certain, or that limits your losses. (I would write another article to illustrate
this using calculations).
For example, say you are an exporter, and your earnings are in dollars. Now, you would receive your payment of
$15000 after six months. But since you spend in Rupees, you would also like to keep track of your earnings in
Rupees.
The value of dollars after six months would decide your actual earning in rupees. Since that is not known right now, it
brings uncertainty to your earnings too. Derivatives can be helpful in such a scenario.
You can buy Dollar Rupee futures contract of $15000 with the rate of Rs. 39.5 for a dollar, and with a validity of 6
months. Thus, you would be certain about your earnings after 6 months whether the rate after 6 months is Rs. 37 or
Rs. 41, you would get Rs. 39.5 for every dollar.
For a business, this kind of certainty in cash flows and earnings can be a very big relief!
Hedging is the primary use of derivatives. But in the market, apart from hedgers, we also have many participants that
use derivatives just for investments people who want to make profits out of the price movement of derivatives just
like stocks.
The presence of such participants is not bad, because they provide liquidity and depth to the derivatives market.
the corn in your morning cereal which you have for breakfast,
the steel which makes your motor car and the crude oil which runs it and takes you to work,
... All these commodities (and dozens more) are traded between hundreds-of-thousands of investors, every day, all
over the world. They are all trying to make a profit by buying a commodity at a low price and selling at a higher price.
Futures trading is mainly speculative 'paper' investing, i.e. it is rare for the investors to actually hold the physical
commodity, just a piece of paper known as a futures contract.
The nearer (to expiration) contracts are usually more liquid, i.e. there are more traders trading them. Therefore, prices
are more true and less likely to jump from one extreme to the other. But if you thought the price of gold would rise until
September, you would choose a further-out contract (October in this case) - a September contract doesn't exist.
Neither is their a limit on the number of contracts you can trade (within reason - there must be enough buyers or
sellers to trade with you.) Many larger traders/investment companies/banks, etc. may trade thousands of contracts at
a time!
All futures contracts are standardised in that they all hold a specified amount and quality of a commodity. For
example, a Pork Bellies futures contract (PB) holds 40,000lbs of pork bellies of a certain size; a Gold futures contract
(GC) holds 100 troy ounces of 24 carat gold; and a Crude Oil futures contract holds 1000 barrels of crude oil of a
certain quality.
Other hedgers of futures contracts include banks, insurance companies and pension fund companies who use futures
to hedge against any fluctuations in the cash price of their products at future dates.
Speculators include independent floor traders and private investors. Usually, they dont have any connection with the
cash commodity and simply try to (a) make a profit buying a futures contract they expect to rise in price or (b) sell a
futures contract they expect tofall in price.
In other words, they invest in futures in the same way they might invest in stocks and shares - by buying at a low
price and selling at a higher price.
or enough margin to cover 2 futures contracts. (Each Gold futures contract holds 100 ounces of gold, which is
effectively what you 'own' and are speculating with. One-hundred ounces multiplied by three-hundred dollars
equals a value of $30,000 per contract. You have enough to cover two contracts and therefore speculate with
$60,000 of gold!)
Two months later, gold has rocketed 20%. Your 10 ounces of gold and your company shares would now be worth
$3600 - a $600 profit; 20% of $3000. But your futures contracts are now worth a staggering $72,000 - 20% up on
$60,000.
Instead of a measly $600 profit, you've made a massive $12,000 profit!
2. Speculating with futures contracts is basically a paper investment. You dont have to literally store 3 tons of gold in
your garden shed, 15,000 litres of orange juice in your driveway, or have 500 live hogs running around your back
garden!
The actual commodity being traded in the contract is only exchanged on the rare occasions when delivery of the
contract takes place (i.e. between producers and dealers the 'hedgers' mentioned earlier on). In the case of a
speculator (such as yourself), a futures trade is purely a paper transaction and the term 'contract' is only used mainly
because of the expiration date being similar to a contract.
3. An investor can make money more quickly on a futures trade. Firstly, because he is trading with around tentimes as much of the commodity secured with his margin, and secondly, because futures markets tend to move more
quickly than cash markets. (Similarly, an investor can lose money more quickly if his judgement is incorrect, although
losses can be minimised with Stop-Loss Orders. My trading method specialises in placing stop-loss orders to
maximum effect.)
4. Futures trading markets are usually fairer than other markets (like stocks and shares) because it is harder to
get inside information. The open out-cry trading pits -- lots of men in yellow jackets waving their hands in the air
shouting "Buy! Buy!" or "Sell! Sell!" -- offers a very public, efficient market place. Also, any official market reports are
released at the end of a trading session so everyone has a chance to take them into account before trading begins
again the following day.
5. Most futures markets are very liquid, i.e. there are huge amounts of contracts traded every day. This ensures
that market orders can be placed very quickly as there are always buyers and sellers of a commodity. For this reason,
it is unusual for prices to suddenly jump to a completely different level, especially on the nearer contracts (those which
will expire in the next few weeks or months).
6. Commission charges are small compared to other investments and are paid after the position has ended.
Commissions vary widely depending on the level of service given by the broker. Online trading commissions can be as
low as $5 per side. Full service brokers who can advise on positions can be around $40-$50 per trade. Managed
trading commissions, where a broker controls entering and exiting positions at his discretion, can be up to $200 per
trade.
For example, say Pork Bellies is trading at $55.00 and you think prices are about to rise. You decide to buy one Pork
Bellies contract, but you don't want to risk more than $800 on the trade. A one-cent move in the market is worth $4.00
on a pork bellies futures contract so, therefore, you would place your stop at $53.00 (200 cents away from the current
price x $4 per point = $800).
You can also move a stop-loss order to protect any profits you accumulate.
Taking the Pork Bellies example: Two weeks later, bellies are now trading at $65.00. You are now up $4000 (1000
cents of movement x $4). To protect these profits, you can raise your stop-loss simply by calling your broker. Say you
place it at $63.00, you have locked it a profit of at least $3200 and now risk $800 to your new stop level.
But what if the market went against you? Going back to the original position when you bought at $55.00 with a stop at
$53.00: what happens if the market suddenly tumbles down to $51.00 during the day? Your trade would automatically
be 'stopped out' at your stop level of $53.00 for an $800 loss. The fact that the market closed the day at $51.00 is
irrelevant as you are now out of the market. (Had you not used a stop-loss and viewed the market at the end of the
day, you would have large losses on your hands!)
The same would happen if the market reached $65.00 and you had raised your stop to $63.00: If the market fell from
here, say to $62.80, you would be stopped out at $63.00 and would have a profit of $3200. Even if the market
suddenly reversed here and rose to $79.00, this would be irrelevant as you are now out of the market.
This last example would be annoying because if you hadn't been stopped out, you would now be $9600 in profit. But
you were stopped out at your $63.00 stop. The market only went 20-cents under this and reversed!
It is for this reason that some traders don't use stops: they have been stopped out in the past JUST when the market
was about to go their way.
The solution is not to abandon using stops as this is EXTREMELY RISKY. The solution is to use stops effectively.
(In fast moving markets it is sometimes impossible for brokers to get your orders exited exactly on your stop loss
limits. They are legally required to do their best, but if the price in the trading pit suddenly jumps over your limit, you
may be required to settle the difference. In the above scenario, the price of Pork Bellies could open trading at $62.50,
fifty cents through your stop at $63.00. Your broker would have to exit your trade here and, in fact, you would lose
$1000, $200 more than your anticipated $800.)
systems claiming 80%+ winning trades on past data, but when I have run the system on current prices, the results are
breakeven at best!)
They normally paper trade the method (i.e. they follow the markets but only pretend to place the trades) for a few
months to make sure the method works for them before placing any actual trades.
Tracking price charts and keeping up with fundamental data is a difficult full-time job some large organisations
employ dozens of staff to follow market moves. And some traders, especially those on the market floor, may only hold
a position for a few hours or even minutes.
So where does this leave the small, independent investor who would like to trade in the lucrative futures markets?
Many trade on a daily or weekly basis, i.e. they note or 'download' market prices at the end of each trading day and
make their decisions from this data. Often, they will leave a trade on for at least a few weeks (possibly months). This is
a much SAFER way of trading because any fluctuations are ridden out and less panic-buying or selling is involved.
None of your trades should risk more than 5% of your trading capital if possible. (And in "trading capital", I mean
money you can afford to, and are prepared to LOSE!) That way, you would have to lose 20 trades in a row in order to
get wiped out.
Spread Betting
Spread betting is a relatively new approach of trading the futures markets. A spread betting company, such as IG
Index, Financial Spreads, or City Index doesnt charge a commission but gets paid on a spread of the market price.
This is usually a couple of points either side of the actual market price, like an ask/bid spread.
For example, say the March Gold contract is trading at $300 per ounce. Depending on which way you wanted to trade,
you may be quoted 298/302.
If you were buying you would enter at $302 two points above the market price.
If you wanted to sell, you would enter at $298 - two points under the market price.
Both the spreads go against your market direction. If the value of one point on the contract was $100, in effect you
would be paying a 2 point spread worth $200.
This is quite a lot more expensive than a normal futures brokerages commission charge and an exchange's ask/bid
charge, and it can be even higher if you place a stop-loss order. (Therefore, spread betting is more suited to longterm trading and not short-term day trading - high commissions will take away any profits.)
But the value of a spread betting contract can be around half that of a real futures contract.
Therefore, the amount of money you need to put into an account, to bet on a commodity, or the amount you can lose,
is about half that of trading a real contract. You can often put a guaranteed stop loss order on your bet, too, which
avoids the pitfalls of 'gapping' prices. (For example, say you were long on Gold and your stop-loss was at 290. The
market opened well down at 285, you would be stopped at 290 with your guaranteed stop. Trading a normal futures
contract, your broker would have to stop you out at 285 and you would lose an extra $500.)
Also, any profits you make from a spread-bet will be free from capital gains tax.
Options Trading
Options trading is available on a number of investments including futures contracts. Options trading is a complete
subject in itself and can be more complicated that futures trading to understand. But basically, using an option gives a
trader the right to buy or sell a contract at a future date, but not the obligation.
The trader needs to pay a premium for this choice which can often work out less expensive than the margin
requirements - or the risk to a stop-loss order - in trading the futures contract. Should the trader not exercise the
option, he would lose the premium he paid for the option. But should he exercise it, he could make a lot of money.
There is a lot of terminology in options trading and it can be more complex than the simple 'buy or sell' method of
futures trading.
1. Gann recommended dividing one's trading capital into 10 equal parts and never using more than 1 part to trade any
commodity. In effect, this risks 10% of trading capital on any position. However, many other top traders such as those
featured in the Market Wizards books recommend using only 1 or 2% per trade.
2. Spread your risk over a range of different markets, for example, stock index, currency, and several commodities like
grain, livestock, energy, metals, industrials, softs.
3. Always use Stop Loss Orders to protect capital whenever you make a trade, and move them to protect profits.
4. Never over-trade. Trading up to 5 or 6 markets at a time has been recommended by some traders such as WD
Gann and Larry Williams.
5. Never let a profit run into a loss. As soon as a trade becomes profitable, move your stop loss to lock in profits.
6. Always trade with the trend, never against it.
7. "When in doubt, get out." If you are unsure of the market position it is safest to exit with a guaranteed profit or small
loss. If you can, try and buy on dips or down-days and sell on peaks or up-days.
8. Avoid congesting markets and only trade in markets that are trending.
9. Trade in a variety of different markets to spread risk.
10. Never close a trade without good reason and follow up with a stop loss order to protect profits.
11. Create a surplus account. When you have made some profits place them aside to use only in an emergency.
12. Never average a loss. Practise on paper until you make regular profits Do this in real-time NOT on historic data
because it is too easy to optimise a trading system to fit past results.
13. Never enter a market just because you have become bored of waiting, or exit a trade because you have lost
patience.
14. Avoid taking small profits and big losses.
15. Never cancel a stop-loss order once you have placed it.
16. Avoid entering and exiting the market too often. Although there are reports of Gann making hundreds of trades in a
small period of time, these were typically for exhibition purposes. In reality, Gann would only make a handful of
commodity trades a year.
17. Be as prepared to sell short as to buy long and always follow the trend.
18. Never buy just because the price of a commodity is low or sell because it is high. For example, just because Crude
Oil fell from $40 to $20 would not be a good buy trade if Crude then fell to $10! (Which it did a few years ago.)
19. Avoid hedging, e.g. buying wheat and covering the position by selling corn; Or buying one Wheat contract month
and selling a different Wheat contract month.
20. Be careful with pyramiding and plunging (adding to positions). For example, if you have bought Oats and the
market keeps falling avoid buying more contracts on the premise that the market ''has to turn soon'' (plunging).
Instead, try and exit for a small loss as soon as the trade has made a small loss.
Similarly, be careful "putting all your eggs in one basket" adding to positions if your analysis has proved correct
(pyramiding). Only consider pyramiding if Rule 1 allows you sufficient funds to do so.
21. Never change your position in the market without good reason.
22. Avoid increasing your trading after a long period of success or failure. It is easy to think of yourself as "invincible"
after winning a succession of trades. This is the reason most gamblers lose money.
23. Never guess when the market is at top or bottom. Always wait for a definite signal first.
24. Never increase trading to win back profits.
talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of
$200,000. The owner agrees, but for this option, you pay a price of $3,000.
Now, consider two theoretical situations that might arise:
1. It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house
skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for
$200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).
2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost
of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in
the basement. Though you originally thought you had found the house of your dreams, you now consider it
worthless. On the upside, because you bought an option, you are under no obligation to go through with the
sale. Of course, you still lose the $3,000 price of the option.
This example demonstrates two very important points. First, when you buy an option, you have a right but not an
obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless.
If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an
option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which
means an option derives its value from something else. In our example, the house is the underlying asset. Most of the
time, the underlying asset is a stock or an index.
Calls and Puts
The two types of options are calls and puts:
1. A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are
similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially
before the option expires.
2. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very
similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the
option expires.
Participants in the Options Market
There are four types of participants in options markets depending on the position they take:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said
to have long positions, and sellers are said to have short positions.
Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their
rights if they choose.
Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be
required to make good on a promise to buy or sell.
Don't worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the
buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there
are two sides of an options contract.
The Lingo
To trade options, you'll have to know the terminology associated with the options market.
The price at which an underlying stock can be purchased or sold is called thestrike price. This is the price a stock price
must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur
before the expiration date.
An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is
known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100
shares of company stock (known as a contract).
For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-themoney when the share price is below the strike price. The amount by which an option is in-the-money is referred to
as intrinsic value.
The total cost (the price) of an option is called the premium. This price is determined by factors including the stock
price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining
the premium of an option is complicated and beyond the scope of this tutorial.
Options Basics: Why Use Options?
There are two main reasons why an investor would use options: to speculate and to hedge.
Speculation
You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't
limited to making a profit only when the market goes up. Because of the versatility of options, you can also make
money when the market goes down or even sideways.
Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason
options have the reputation of being risky. This is because when you buy an option, you have to be correct in
determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement.
To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much
the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The
combinations of these factors means the odds are stacked against you.
So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about
using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to
generate substantial profits.
Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car,
options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of
your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that
hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that
you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By
using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way. (For
more on this, see Married Puts: A Protective Relationship and A Beginner's Guide To Hedging.)
A Word on Stock Options
Although employee stock options aren't available to everyone, this type of option could, in a way, be classified as a
third reason for using options. Many companies use stock options as a way to attract and to keep talented employees,
especially management. They are similar to regular stock options in that the holder has the right but not the obligation
to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option
is a contract between two parties that are completely unrelated to the company
Options Basics: How Options Work
Now that you know the basics of options, here is an example of how they work. We'll use a fictional firm called Cory's
Tequila Company.
Let's say that on May 1, the stock price of Cory's Tequila Co. is $67 and the premium (cost) is $3.15 for a July 70 Call,
which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is
$3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this
example.
Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to
get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is
worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15.
When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've
paid $315 for the option, so you are currently down by this amount.
Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now
worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You
almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and
take your profits - unless, of course, you think the stock price will continue to rise. For the sake of this example, let's
say we let it ride.
By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left,
the option contract is worthless. We are now down to the original investment of $315.
To recap, here is what happened to our option investment:
Date
May 1
May 21
Expiry Date
Stock Price
$67
$78
$62
Option Price
$3.15
$8.25
worthless
Contract Value
$315
$825
$0
Paper Gain/Loss
$0
$510
-$315
The price swing for the length of this contract from high to low was $825, which would have given us over double our
original investment. This is leverage in action.
Exercising Versus Trading-Out
So far we've talked about options as the right to buy or sell (exercise) the underlying. This is true, but in reality, a
majority of options are not actually exercised.
In our example, you could make money by exercising at $70 and then selling the stock back in the market at $78 for a
profit of $8 a share. You could also keep the stock, knowing you were able to buy it at a discount to the present value.
However, the majority of the time holders choose to take their profits by trading out (closing out) their position. This
means that holders sell their options in the market, and writers buy their positions back to close. According to the
CBOE, about 10% of options are exercised, 60% are traded out, and 30% expire worthless.
Time Value
$0.25
In real life options almost always trade above intrinsic value. If you are wondering, we just picked the numbers for this
example out of the air to demonstrate how options work.
American options can be exercised at any time between the date of purchase and the expiration date. The
example about Cory's Tequila Co. is an example of the use of an American option. Most exchange-traded
options are of this type.
European options are different from American options in that they can only be exercised at the end of their
lives.
The distinction between American and European options has nothing to do with geographic location.
Long-Term Options
So far we've only discussed options in a short-term context. There are also options with holding times of one, two or
multiple years, which may be more appealing for long-term investors.
These options are called long-term equity anticipation securities(LEAPS). By providing opportunities to control and
manage risk or even to speculate, LEAPS are virtually identical to regular options. LEAPS, however, provide these
opportunities for much longer periods of time. Although they are not available on all stocks, LEAPS are available on
most widely held issues.
Exotic Options
The simple calls and puts we've discussed are sometimes referred to as plain vanilla options. Even though the subject
of options can be difficult to understand at first, these plain vanilla options are as easy as it gets!
Because of the versatility of options, there are many types and variations of options. Non-standard options are
called exotic options, which are either variations on the payoff profiles of the plain vanilla options or are wholly different
products with "option-ality" embedded in them.
Implied Volatility (IV) Bid/Ask (%): This value is calculated by an option pricing model such as the Black-Scholes
model, and represents the level of expected future volatility based on the current price of the option and other known
option pricing variables (including the amount of time until expiration, the difference between the strike price and the
actual stock price and a risk-free interest rate). The higher the IV Bid/Ask (%)the more time premium is built into the
price of the option and vice versa. If you have access to the historical range of IV values for the security in question
you can determine if the current level of extrinsic value is presently on the high end (good for writing options) or low
end (good for buying options).
Delta Bid/Ask (%): Delta is a Greek value derived from an option pricing model and which represents the "stock
equivalent position" for an option. The delta for a call option can range from 0 to 100 (and for a put option from 0 to
-100). The present reward/risk characteristics associated with holding a call option with a delta of 50 is essentially the
same as holding 50 shares of stock. If the stock goes up one full point, the option will gain roughly one half a point.
The further an option is in-the-money, the more the position acts like a stock position. In other words, as delta
approaches 100 the option trades more and more like the underlying stock i.e., an option with a delta of 100 would
gain or lose one full point for each one dollar gain or loss in the underlying stock price. (For more check out Using the
Greeks to Understand Options.)
Gamma Bid/Ask (%): Gamma is another Greek value derived from an option pricing model. Gamma tells you how
many deltas the option will gain or lose if the underlying stock rises by one full point. So for example, if we bought the
March 2010 125 call at $3.50, we would have a delta of 58.20. In other words, if IBM stock rises by a dollar this option
should gain roughly $0.5820 in value. In addition, if the stock rises in price today by one full point this option will gain
5.65 deltas (the current gamma value) and would then have a delta of 63.85. From there another one point gain in the
price of the stock would result in a price gain for the option of roughly $0.6385.
Vega Bid/Ask (pts/% IV): Vega is a Greek value that indicates the amount by which the price of the option would be
expected to rise or fall based solely on a one point increase in implied volatility. So looking once again at the March
2010 125 call, if implied volatility rose one point from 19.04% to 20.04%, the price of this option would gain $0.141.
This indicates why it is preferable to buy options when implied volatility is low (you pay relatively less time premium
and a subsequent rise in IV will inflate the price of the option) and to write options when implied volatility is high (as
more premium is available and a subsequent decline in IV will deflate the price of the option).
Theta Bid/Ask (pts/day): As was noted in the extrinsic value column, all options lose all time premium by expiration.
In addition, "time decay" as it is known, accelerates as expiration draws closer. Theta is the Greek value that indicates
how much value an option will lose with the passage of one day's time. At present, the March 2010 125 Call will lose
$0.0431 of value due solely to the passage of one day's time, even if the option and all other Greek values are
otherwise unchanged.
Volume: This simply tells you how many contracts of a particular option were traded during the latest session.
Typically though not always - options with large volume will have relatively tighter bid/ask spreads as the competition
to buy and sell these options is great.
Open Interest: This value indicates the total number of contracts of a particular option that have been opened but
have not yet been offset.
Strike: The "strike price" for the option in question. This is the price that the buyer of that option can purchase the
underlying security at if he chooses to exercise his option. It is also the price at which the writer of the option must sell
the underlying security if the option is exercised against him.
A table for the respective put options would similar, with two primary differences:
1. Call options are more expensive the lower the strike price, put options are more expensive the higher the
strike price. With calls, the lower strike prices have the highest option prices, with option prices declining at
each higher strike level. This is because each successive strike price is either less in-the-money or more outof-the-money, thus each contains less "intrinsic value" than the option at the next lower strike price.
With puts, it is just the opposite. As the strike prices go higher, put options become either less-out-of-themoney or more in-the-money and thus accrete more intrinsic value. Thus with puts the option prices are
greater as the strike prices rise.
2. For call options, the delta values are positive and are higher at lower strike price. For put options, the delta
values are negative and are higher at higher strike price. The negative values for put options derive from the
fact that they represent a stock equivalent position. Buying a put option is similar to entering a short position in
a stock, hence the negative delta value.
Option trading and the sophistication level of the average option trader have come a long way since option trading
began decades ago. Today's option quote screen reflects these advances.
An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a
specific price on or before a certain date.
Options are derivatives because they derive their value from an underlying asset.
A call gives the holder the right to buy an asset at a certain price within a specific period of time.
A put gives the holder the right to sell an asset at a certain price within a specific period of time.
There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and
sellers of puts.
Buyers are often referred to as holders and sellers are also referred to aswriters.
The price at which an underlying stock can be purchased or sold is called the strike price.
The total cost of an option is called the premium, which is determined by factors including the stock price,
strike price and time remaining untilexpiration.
Employee stock options are different from listed options because they are a contract between the company
and the holder. (Employee stock options do not involve any third parties.)
As your knowledge of puts and calls grows, you will want to consider trading strategies that can be used to make
money in the options market. One of these is buying call options and then selling or exercising them to earn a profit.
Covering a call is the act of selling calls to someone in the market in exchange for the option premium. When you're
buying a call, you will be paying the option premium in exchange for the right (but not the obligation) to buy shares at a
fixed price by a certain expiry date. (If you need to brush up on the basics of option trading, please see the Options
Basics Tutorial.)
Trading Calls: Is It My Calling?
The popular misconception that over 90% of all options expire worthless frightens a lot of investors. They believe this
incorrect statistic and then conclude that, if they buy options, they will lose money 90% of the time! This is completely
false. In fact, according to the CBOE, about 30% of options expire worthless, while 10% are exercised and the other
60% are traded out or closed by creating an offsetting position.
The focus of this article is the technique of buying calls and then selling them or exercising them for a profit. We will
not consider selling calls and then buying them back at a cheaper price - this is called naked call writing and is a more
advanced topic. (To learn more, read Naked Call Writing or To Limit Or Go Naked, That Is The Question.).
In this article the term "trading calls" means first buying a call and then closing out the position later - such a strategy
is called "going long" on a call. (To learn more about making money going long on a put, see Prices Plunging? Buy A
Put!)
As you can see from the graph, the payoffs for each investment are different. While buying the stock would require an
investment of $5,000, you could, with an option, control an equal number of shares for only $300. You'll also note that
the break-even point on the stock trade is $50 per share, while the break-even on the option trade is $53 per share
(ignoring all commissions).
The key point, however, is that while both investments have unlimited upside within the next month, the losses on the
options are capped at $300, while the potential losses on the stock could go all the way to $5,000. Remember that
buying a call option gives you the right but not the obligation to buy the stock, so your maximum losses are the
premiums you paid.
Closing Out The Position
You can close out your call position by selling the call back into the market or by having the calls exercised, in which
case you would have to deliver cash to the person who sold you the call. Say that in our example, the stock was at
$55 near expiry. You could sell your call for approximately $500 ($5 x 100 shares), which would give you a net profit of
$200 ($500 minus the $300 premium). Alternatively, you could have the calls exercised, in which case you would have
to pay $5,000 ($50 x 100 shares), and the person who sold you the call would deliver the shares. With this approach,
your profit would also be $200 ($5,500 - $5,000 - $300 = $200). Note that the payoff from exercising or selling the call
is identical: a net of $200.
Conclusion
Trading calls can be a great way to increase your exposure to a certain stock without tying up a lot of funds. Because
options allow you to control a large amount of shares with relatively little capital, they are used extensively by mutual
funds and large investors. As you can see, trading calls can be used effectively to enhance the returns of a stock
portfolio.
Options give investors the right but no obligation to trade securities, likestocks or bonds, at predetermined
prices, within a certain period of time specified by the option expiry date. A call option gives its buyer the option
to buy an agreed quantity of a commodity or financial instrument, called the underlying asset, from the seller of
the option by a certain date (the expiry), for a certain price (the strike price). A put option gives its buyer the right
to sell the underlying asset at an agreed-upon strike price before the expiry date.
The party that sells the option is called the writer of the option. The option holder pays the option writer a fee
called the option price or premium. In exchange for this fee, the option writer is obligated to fulfill the terms of the
contract, should the option holder choose to exercise the option. For a call option, that means the option writer is
obligated to sell the underlying asset at the exercise price if the option holder chooses to exercise the option. And
for a put option, the option writer is obligated to buy the underlying asset from the option holder if the option is
exercised.
Comparison chart
Differences Similarities
Definition
Costs
Obligations
Value
Analogies
Call Option
Put Option
Although options should be part of any balanced portfolio, when it comes to buying stocks that you don't plan to keep
in your account for the long haul, nothing beats using call options as a short-term surrogate. Not only can you close
the position at any time (or simply wait until expiration, when it gets closed for you), but you can bank similar returns
for a fraction of the cash outlay.
In fact, you can be making even more money on the capital you'd originally planned to allocate to stock buying. So,
when someone tells you that you have to spend money to make money, you can show them the fat returns you're
making by saving money instead of spending it all in one place!
In fact, you can greatly reduce your risk if you take your 500 shares of ABC stock, sell it, and then buy five ABC call
options that are in the money by a few strike prices.
(I'll explain which expiration date the call options should have in a minuteand yes, that's important.)
If ABC is trading at $60 per share and you pull up the option chain and look at the 2009 January calls, you might see
the following call options available:
* ABC Jan 60 calls trading at $9 (These are at the money)
* ABC Jan 55 calls trading at $12 (These are in the money by one strike price.)
* ABC Jan 50 calls trading at $15 (These are in the money by two strike prices.)
* ABC Jan 45 calls trading at $18.50 (These are in the money by three strike prices.)
Make Money By Spending Less
It makes more senseinstead of buying 500 shares of ABC stock at $60 (for $30,000)to buy five of the ABC Jan 45
calls at $18.50 (for $9,250). Then, put the remaining $20,750 in a money market account and earn a 5% return on that
"extra" cash.
In this case, the intrinsic value of the Jan 45 call is $15 (because the stock price of $60 minus the strike price of $45 =
$15) and the extrinsic value of the call option is the remaining $3.50 (because the call costs $18.50 minus $15 intrinsic
value = $3.50).
This means that during the life of the call option (especially in the last few months leading up to the January
expiration), that $3.50 extrinsic value (i.e., "time value") deteriorates. So, if your ABC stock trades flat at $60 for the
next few months, the option would lose $3.50 and be worth $15.
Keep in mind that the $3.50 loss (assuming that you actually held on for the next few months) is a loss of $1,750. But,
since you put the rest into a risk-free money market account, you would have earned $1,383.33 in interest.
So, the loss is reduced to $366.67. (And that would equate to 73 cents of the call option instead of $3.50 per share.)
So, what are you getting in return for your willingness to lose 73 cents during the course of a few months on a $60
stock that really only equates to 1.21%?
Number One: Broader Market Downtrends are Less Nervewracking
You know that your absolute maximum downside risk is the $18.50 (or $9,250) that you invested in the call option,
instead of the $60 (or $30,000) on the stock that likely wouldn't lose all of its value. But, as we know, a loss of anything
between one cent and $30,000 is possible.
There are many benefits here that one wouldn't consider at first. One of them is the psychological gain. I mean, you
would be a lot less worried about the stock market crashing, and this would allow you to feel more confident about
buying when people are fearful. That means that you would be buying when things are down.
Also remember that you should usually play both sides of the market. So, you can also buy in-the-money put options
to bet on the downside. That means if the stock is at $60, and you were betting that it would trade lower, you would
buy the in-the-money Jan 75 puts.
Number Two: Similar Gains to Buying the Stock
If your stock moves higher, you are making almost the same amount that you would have made on the stock.