Managed Funds

Glossary

Investors who have a view on where a stocks headed have an alternative to buying or selling those shares outright they can take out an options contract.

Options open up the opportunity for profit if the share price moves in the direction the investor expects and limit risk if things dont go their way.

Sophisticated investors can take advantage of mispricings in the market by using some more complex options strategies.

What is an Option?

An option is a contract between two parties whereby the buyer (or taker) of the option has the right, but not the obligation, to trade an underlying asset (usually a parcel of shares) at a predetermined price on or before a predetermined date.

As the buyer of an option has the advantage in deciding, ultimately, whether to exercise the option the buyer pays a premium upfront to the seller (or writer) of the option.

There are two types of options: call options and put options.

A call option gives the buyer of the option the right but not the obligation to buy an underlying asset at a future date at a predetermined price on or before a predetermined date.

A put option gives the buyer of the option the right but not the obligation to sell an underlying asset at a future date at a predetermined price on or before a predetermined date.In addition, options can be European-style or American-style.

A European option can only be exercised at expiry (that is, on a set date), while an American option can be exercised at any time up to expiry. If an American option isnt exercised before expiry then its effectively a European option.

The ability to exercise before expiry gives the option holder greater flexibility and thus the price of an American option is at least as high as an equivalent European option.

Key Terms

• Underlying asset the asset (such as shares) thats going to be bought or sold.
• Expiry the time when the asset is to be bought or sold (in the case of American-style options, the last date to buy/sell).
• Exercise price or strike price the price at which the asset will be bought or sold.
• Contract size the number of shares underlying an option contract (usually 1000 shares).
• Premium the amount paid by the buyer to acquire the option.
• Taker the buyer of the option.
• Writer the seller of the option.

Using Options

Ignoring transaction costs, options trading represents a zero-sum game. What options do, though, is allow the transfer of risk between various market participants. These participants can be divided into three main groups: hedgers, speculators and arbitrageurs.

Hedgers buy or write options to reduce risk.

Speculators buy or write options to make a profit.

Arbitrageurs buy or write options to earn risk-free profits from market mispricings.

Lets look at some examples.

Hedging with put options

Lets say a portfolio manager has $1 million invested in AAA Ltd shares and hes worried the share price (currently $10) will decline over the next month.

Instead of selling the shares now, the portfolio manager can buy put options with an exercise price of $10 that expire in one months time.

If the price of the shares falls below $10, he can exercise the put option and sell the shares at the existing price of $10 in one months time. If the share price rises he simply lets the option expire and holds onto the shares.

Speculating with call options

An investor thinks ABC shares, currently worth $10, will grow in value over the next six months.

Rather than buying shares outright now, the investor buys call options with an exercise price of $10 that expire in six months time.

If the share price rises above $10, the gambler can exercise his call option and buy the shares in six months time for $10 below the prevailing market price.

Exercising Options

As discussed, the buyer of an option has the right, but not the obligation, to exercise the option. The decision to exercise depends on the price of the underlying asset at expiration.

There are three possible outcomes. An option can be:

In the money, in which case it will definitely be exercised.

• At the money, in which case the buyer of the option will be indifferent to exercising.
• Out of the money, in which case the buyer of the option will not exercise the option.

Just as the decision to exercise an option depends on a comparison of the asset value with the exercise price, the actual payoff from an option depends on whether the option is a call or a put, whether the option is held long (or bought) or short (sold) and whether the option finishes in the money, at the money or out of the money.

In the case of call options:

• The buyer of a call profits when the asset increases in value.
• The writer of a call profits by the amount of the premium when the option isnt exercised.

In the case of put options:

• The buyer of a long put profits when the asset decreases in value.
• The writer of a put profits by the premium when the option isnt exercised.

Quiz 1

Question 1: Whats the payoff from a contract of call options (1000 options) on ABC with a strike price of $25 when the expiration stock price is $27.50?

Profit = (30 26.5) x 1000 2 x 1000 = $1,500. If the stock price rose to $32, the option would not be exercised, and the loss on the strategy would amount to $2,000 (the initial option premium).

Factors Affecting Option Prices

The factors that affect option prices are the underlying asset price, the strike price, the time to maturity, the underlying asset volatility, the risk-free rate of interest (a theoretical rate based on a short-term benchmark) and any income the underlying asset will pay.

Asset prices and strike prices

Call options become more valuable as the share price increases and less valuable as the exercise or strike price decreases. Put options behave in the opposite way.

For example, if a call option has an exercise price of $10 and the price of the underlying shares increases from $11 to $12, then the payoff increases from $1 to $2. This increased payoff will lead to an increase in the option price.

Time to expiry

For American calls and puts, the longer the time to expiry, the more valuable the option (because theres more time for an option to end in the money). With European calls and puts, theres no definite relationship between time to expiry and price (especially for dividend-paying stocks).

Volatility

As the owner of an option decides whether to exercise or not, an increase in the volatility of the underlying asset increases the value of all options.

Risk-free interest rate

An increase in interest rates leads to an increase in American and European call prices, but decreases American and European put prices.

Income

Income from the underlying asset share dividends reduces the value of American and European call options but increases the value of American and European put options

This table summarises the effect on option prices of increasing one variable while the others remain constant.