Risk Management, Risk Transfer, Financial Leverage

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 44

OPTIONS

Uses of Derivatives:

1. Risk Management:

Instead of wheat, imagine that your crop is equity securities: You want their value to grow

and generate capital gains. Your focus is more on investor demand than on supply. When

the country goes on the stock-buying binge, prices go up. When people get cold feet and

retreat from the market, prices go down. This market risk phenomenon is generally

analogous to the farmer's price risk. Similarly, someone holding bonds faces a potential for

a paper loss should interest rates unexpectedly. Derivative assets, especially interest rate

futures, can be used to reduce the interest rate risk.

2. Risk Transfer:

Derivatives are much more convenient (and less expensive) to use than security purchases

or sales each time the portfolio manger decides to alter market exposure. Futures and

options provide a means for risk to be transferred from one person to some other market

participant who, for a price is willing to bear it.

3. Financial Leverage:

Derivatives may provide financial leverage, which is one of the primary reasons some

speculators use them. As an example, an investor may feel that Ionics, Inc. (ION, NYSE), a

manufacturer of water treatment products, is an excellent take over candidate. If that

investor bought 100 shares of this stock at $29, the cost would be $2,900. As an alternative

the investor could speculate on takeover rumors using a single stock option selling for

perhaps $300. With this position, the investor would benefit from a sharp increase in the

stock price, but would have only a modest amount of money at risk. The worst that could

happen is that the investor would lose all $300. On the other hand, an investor who bought

the stock could lose much more than that if the stock plummeted.

4. Income Generation:

Some people use derivatives as a means of generating additional income from their

investment portfolio. Options are widely used for this purpose in the portfolios of

endowment funds, pension funds, and individual portfolios.

5. Financial Engineering:

Just as the chemist mixes compounds in the laboratory to produce something with known

characteristics, a financial engineer can mix financial assets in such a way that portfolio has

special characteristics. Derivative assets are the basic building blocks the engineer uses.

Some of the recent financial disasters involving derivatives occurred because the product

mix was the potentially volatile. Nitroglycerin can be use to treat heart disease, but masked

men of the Wild west also used it to blow up trains. Slight variations in the composition of

portfolio can result in drastically different characteristics.

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Investment Analysis & Portfolio Management (FIN630)

What's next?

It is unlikely that we have seen the last of innovation in the derivative assets markets. Many

brilliant minds are searching for a better mousetrap in the areas of risk management and

income generation. As with much of scientific discovery, what is commonplace today

would have been a marvel just a few years ago. One thing that is certain is that these

products are the permanent features of the financial landscape. An informed investment

professional needs a basic understanding of their uses and potential risks.

The Origin of an Option:

Two parties are necessary to trade; if someone buys an option, someone else has to sell it.

Unlike more familiar securities such as shares of stock, there is no set number of put or call

options. In fact, the number in existence changes every day. Options can be destroyed. This

unusual fact is crucial to understanding the options market.

The first someone makes in a particular is called an opening transaction. When the option is

subsequently closed out with a second trade (or with expiration of the option), this latter

trade is called a closing transaction. Purchases and sales can be either type of transaction.

Buying something as an opening transaction is perhaps easier to understand than selling

something as an opening transaction. Returning to the football ticket example, the university

created the tickets and sold them; this was an opening transaction for the university. When

an option is sold as an opening transaction, it is called writing an option.

No matter what the owner of an option does, the writer of the option keeps the option

premium. The university keeps the $ 24 you paid for the two tickets whether you go the

game or not.

Options have an important characteristic called fungibility, meaning that, for a given

company, all options of the same type with the same expiration and striking prince are

identical. Just as a $1 bill is equivalent to any other $ bill, a Microsoft APR 90 call written

today is equivalent to a Microsoft APR 90 call written last month. Fungibility is particularly

important to the option writer. An investor who writes an option receives premium for doing

so. If market conditions changes a week later, the investor can buy an identical option and

close out the position. The investor pays for the option purchased, which may be more or

less than the amount received when the investor wrote the option. The important point is

that the option need not be repurchased from the specific person to whom it was sold,

because the options are fungible.

THE OPTIONS MARKET:

Options:

Which represent claims on an underlying common stock, are created by investors and sold

to other investors? The corporation whose common stock underlies these claims has no

direct interest in the transaction, being in no way responsible for the creating, terminating,

or executing put and call contracts.

Contracts giving the owner the Tight to buy or sell the underlying asset

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Investment Analysis & Portfolio Management (FIN630)

Call:

An option to buy a stock at a sated price within a specified period of months

A call option gives the holder the right to buy (or "call away") 100 shares of a particular

common stock at a specified price any time prior to a specified expiration date. Investors

purchase calls if they expect the stock price to rise, because (lie price of the call and the

common stock will move together. Therefore, calls permit investors to speculate on a rise in

the price of the underlying common stock without buying the stock itself.

Put:

An option to sell a stock at a stated price within a specified period of months

A put option gives the buyer the right to sell (or "put away") 100 shares of a particular

common stock at a specified price prior to a specified expiration date. If exercised, the

shares are sold by the owner (buyer) of the put contract to a writer (seller) of this contract

who has been designated to take delivery of the shares and pay the specified price. Investors

purchase puts if they expect the stock price to foil, because the value of the put will rise as

the stock price declines. Therefore, puts allow investors to speculate on * decline in the

stock price without selling the common stock short.

Why Options Market?

An investor can always purchase shares of common stock if he or she is bullish about the

company's prospects or sell short if bearish. Why then should we create these indirect

claims on a stock as an alternative way to invest? Several reasons have been advanced, in-

cluding the following:

1. Puts and call expand the opportunity set available to investors, making available

risk-return combinations that would otherwise be impossible or that improve the-

risk-return characteristics of a portfolio. For example, an investor can; sell the stock

short and buy a call, thereby decreasing the risk on the short sale for the life of the

call.

2. In the case of calls, an investor can control (for a short period) a claim on the

underlying common stock for a much smaller investment than required to buy the

stock itself. In the case of puts, an investor can duplicate a short sate without a

margin account and at a modest cost in relation to the value of the stock. The buyer's

maximum loss is known in advance. If an option expires worthless, the most the

buyer can lose is the cost (price) of the option.

3. Options provide leverage magnified percentage gains in relation to buying the stock;

furthermore, options can provide greater leverage than fully margined, stock

transactions.

4. Using options on a market index such as the Standard & Poor's 500 Composite

Index (S&P 500), an investor can participate in market movements with a, single

trading decision.

Understanding Options:

To understand puts and calls, one must understand the terminology used in connection

with them. Our discussion here applies specifically to options on the organized exchanges

as reported daily in such sources as The Wall Street Journal.4 Important options terms

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Investment Analysis & Portfolio Management (FIN630)

include the following:

1. Exercise (strike) price:

The exercise (strike) price is the per-share price at which the common stock may be

purchased (in the case of a call) or sold to a writer (in the case of a put). Most stocks in the

options market have options available at several different exercise prices, thereby providing

investors with a Choice. For stocks with prices greater than $25, the strike price changes in

increments of $5, whereas for those under $25, the increment is $2.50. As the stock price

changes, options with new exercise prices are added.

2. Expiration date:

The expiration date is the last date at which an option can be exercised. All puts and calls

are designated by the month of expiration. The options exchanges currently offer sequential

options and-other shorter term patterns. The expiration dates for options contracts vary from

stock to stock but do not exceed nine months.

3. Option premium:

The option premium is the price paid by. the option buyer to the writer (seller) of the option

whether put or call. The premium is stated on a per-share basis for options on organized

exchanges; and since the standard contract is for 100 snares, a $3 premium represents $300,

a $15 premium represents $1500, and so forth. Information on options premiums can be

found on The Wall Street Journal's "Listed Options Quotation" page. The most active

contracts for the day are reported along, with some individual equity options. Information

about index options is also available on this page.

The options page of The Wall Street Journal, as well as other sources, also carries the

information for long-term options known as long-term equity anticipation securities

(LEAPS), which were introduced in 1990. These long-term options, available on roughly

450 stocks and several indexes, trade on four U.S. exchanges. All LEAPS options for

stocks expire in January, and for indexes, December. Maturities extend out to about two

and one-half years.

LEAPS are typically more expensive than short-term options, but with a longer maturity,

they may cost less per share when calculated on a daily basis. Like short-term options, they

can be used to hedge-or speculate.

Standardized Options Characteristics:

Features:

All options have standardized expiration dates. For most options, it falls on the Saturday

following the third Friday designated months. Individual investors typically view the third

Friday of the month as the expiration date, because exchanges are closed to public trading

on Saturday.

Striking prices are established at multiples of 2 ½ or $5 depending on the current stock

price. Stocks priced at $25 or below have the low multiple, while higher period stocks have

the $5 multiple. Shifts in the price of a stock result in the creation of new striking prices. As

a matter of policy there is always at least one striking price above and at least below the

current stock price.

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Investment Analysis & Portfolio Management (FIN630)

Both puts and calls are based on 100 shares of the underlying security. As investor who

buys a call option on the stock of particular company is purchasing the right to buy 100

shares of stick. It is not possible to buy or sell odd lots of options.

The Premium:

The premium has two components: intrinsic value and time value. For a call option,

intrinsic value equals stock price minus striking price; for a put, intrinsic value equals

striking price minus stock price. In some respects, determining intrinsic value is the first

step in valuing an option. By convention, intrinsic value cannot be less than zero. Time

value is equal to the option premium minus the intrinsic value.

If an option has no intrinsic value, it is out-of-the-money, if it does have intrinsic value, it is

in-the-money. In special when an option's striking price is exactly equal to the price of

underlying security, the option is at-the-money.

Intrinsic

Time value

Option

value

How Options Work:

noted, a standard call' (put) contract gives the buyer the right to purchase (sell) 100

shares of a particular stock at a specified exercise price any time before the expiration date.

Both puts and calls are created by sellers who write a particular contract. Sellers (writers)

ate investors, either individuals or institutions, who seek to profit from their beliefs about

the underlying stock's likely price performance, just as the buyer does.

The buyer and the seller have opposite expectations about the likely performance of the

underlying stock, and therefore the performance of the option.

1. The call writer expects the price of the stock to remain roughly steady or perhaps

move down.

2. The call buyer expects the price of the stock to move upward relatively soon.

3. The put writer expects the price of the stock to remain roughly steady or perhaps

move up.

4. The put buyer expects the price of the stock to move down relatively soon.

THE MECHANICS OF TRADING:

The Options Exchanges:

Five option exchanges constitute the secondary market: the Chicago Board Options

Exchange (CBOE), the American, the Philadelphia, the Pacific, and the newer International

Securities Exchange (1SE) in New York. Traditionally, the first four exchanges controlled

the trading of U.S. options, each handling different options and competing very little. The

ISE began trading in May 2000, and now has a substantial share of U.S. trading volume in

options. This all-electronic market is extremely efficient, and has forced the other four

exchanges to handle all options. This competition has led to lower costs and narrower

spreads for customers, and quicker access to the market.

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Investment Analysis & Portfolio Management (FIN630)

The options markets provide liquidity to investors, which is a very important requirement

for successful trading. Investors know that they can instruct their broker to buy or sell

whenever they desire at a price set by the forces of supply and demand. These exchanges

have made puts and call a success by standardizing the exercise date and exercise price of

contracts.

The Clearing Corporation:

The options clearing corporation (OCC) performs a number of important functions that

contribute to the success of the secondary market for options. H functions as an

intermediary between the brokers representing the buyers and the writers. That is, once the

brokers representing the buyer and the seller negotiate the price on the floor of the

exchange, they no longer deal with each other but with the OCC.

Through their brokers, call writers contract with the OCC itself to deliver shares of

the particular stock, and buyers of calls actually receive the right to purchase the shares

from the 0CC Thus, the OCC becomes the buyer for every seller and the seller for every

buyer, guaranteeing that all contract obligations will be met. This prevents the problems

that could occur as buyers attempted to force writers to honor their obligations. The net

position of the OCC is zero, because the number of contracts purchased must equal the

number sold.

Investors wishing to exercise their options inform their brokers, who in turn inform the

OCC of the exercise. The OCC randomly selects a broker on whom it holds the same

written contract, and the broker randomly selects a customer who has written these options

to honor the contract. Writers chosen, in this manner are said to be assigned an obligation or

to have received an assignment notice. Once assigned, the writer cannot execute an

offsetting transaction to eliminate the obligation; .that is, a call writer who receives an

assignment must sell the underlying securities, and a put writer must purchase them.

One of the great advantages of a clearinghouse is that transactors in this market can easily

cancel their positions prior to assignment. Since the OCC maintains all the positions for

both buyers and sellers, it can cancel out the obligations of both call and put writers wishing

to terminate their position. With regard to puts and calls, margin refers to the collateral than

option writers provide their brokers to erasure fulfillment of the contract in case of exercise.

Options cannot be purchased on margin. Buyers must pay 100 percent of the purchase price.

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