Vipin Garg

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

We are going to talk majorly about options over the 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 but not obligation to buy or sell tan underlying asset or instrument at a specified strike price on or before a specified date. Counterparty 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 buyer pays a premium to the seller of the option. Most widely used options are “Call” and “Put”. Call gives the buyer right to right to buy an underlying at specified price whereas Put confer the right to sell an underlying at specified price to the buyer.

Options are different from forward and futures

Forward and futures 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 trader/investor to establish a position in the anticipated direction.

Applications of Options

Options can be put to majorly 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 maximize 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 immune the investment from the downturn. It aims at minimizing the losses of the investor and traders.

 Delta Hedging

“Delta” is 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.

Whereas Put option delta are negative because as 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 individual investor.

• To hedge the equity positions. Equity dealers, traders, portfolio Managers use options as the tools of hedging their equity positions. In this manner they minimize their loses.

Let’s say  an equity trader buys 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 loss to $5 which is the premium he pays to get the exercise option

• Used by the companies and manufactures 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 need to understand that Value of the options is highly impacted by the Volatility of the underlying asset and the time remaining in 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 prices of security can vary sharply in very short time period.  Lower volatility implies prices of a security move steadily. Higher Volatility implies higher risk.

Each Market has Volatility index to gauge how volatile is the market. 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’s excess bearishness, and low numbers indicate excess bullishness

Volatility and the pricing of options

Price of the option consists of two components:

• Intrinsic Value: 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: 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 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 be .05. Thus, for increase/decrease in volatility by one point value of option 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.

 Impact of time on the value of the 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 highest level when option is at-the-money as 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 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 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.

In the next instalment we will implement some strategies using call and put options. Please share your feedback.