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Options and warrants are types of derivatives; that is, their value is derived from an underlying asset. This underlying asset, in the trading sense, is usually a bond, currency, futures contract or share. For the sake of simplicity, we will only discuss derivatives on Australian shares here. Derivatives first came into existence to give shareholders a way of protecting the value of their shares for a short period of time without having to sell the shares in the market. They also give speculators wishing to accept risk the opportunity to make some very rapid profits. Derivatives, therefore, can be considered as a type of insurance.
Take the example of insuring your car. You are concerned that you might damage your car and that if you did, you wouldn't be able to afford the loss. Therefore, you pay an insurance company a small premium (compared to the value of the car) and they will keep this premium no matter what happens to your car. However, if you do happen to damage your car, thereby lowering the value of the car, the insurance company will give you the amount you originally negotiated to add value back to your car.
Let's compare this to a scenario in which you own Newscorp shares: You are concerned that the value of the shares may fall. If they did, you wouldn't be able to afford the loss. Therefore, you pay a seller of an option a small premium (compared to the value of the shares) and they will keep this premium no matter what happens to your shares. However, if your shares do happen to fall in value, the seller of the option will give you the agreed amount you originally negotiated.
What is essentially happening is that in both instances you are protecting the value of your asset or 'hedging' your risk. The insurance company and the seller of the option have taken the risk away from you in the hope of making profits. The great thing about the derivatives market is that it often allows you to be either the buyer or seller of insurance (options).
An option gives the buyer of the option the right, but not the obligation, to buy or sell a specified share at a certain price at or before (American) a certain date in the future. The seller keeps the amount paid for the option (the premium) but has the obligation to sell or buy that specified asset from the buyer of the option.
This definition may sound very legal and 'wordy' but it should become quite clear as we go through it step by step.
There are a few subtle differences between a warrant and an option, the main one being that a warrant is usually issued by a third party (e.g. an investment bank). However, the term 'option' will be used here to cover both warrants and options.
Options are legal contracts. Under the rules, regulations and laws of various exchanges, buyers and sellers of derivatives are legally obliged to fulfill their side of the contract. In our daily lives, contracts are usually between two or more parties and each party must fulfill certain requirements to uphold their obligations within the contract. The difference with options is that it gives exactly that - an option. There are only two parties to an option contract (the buyer and the seller) with only the seller of the option having to transact IF and only IF the buyer of the option wishes to do so. This explains the,"...right but not the obligation...," part of the definition. It is important to remember with options that they have a secondary market. That is, a trader may forfeit all contract obligations by selling the option (if they previously bought the option) or buying the option (if they previously sold the option)* on the market or with the original counter party (if the opportunity to do so exists). The trader doesn't need to wait until the expiry date.
*NB. Options may be sold without having bought the option first. By 'closing a position' a trader sells an option or asset after having already bought it, or they buy an option or asset having previously sold it.
The price is the amount that the buyer of the option will purchase or sell the shares from (or to) the seller of the option e.g. the buyer of the option may want to buy Newscorp shares at $15.00. Remember, the seller is obliged to sell the Newscorp shares to the option buyer at $15.00 should the option buyer wish to so. This $15.00 price is known as the 'strike price' or 'exercise price'.
The certain date in the future means the date up to which the option contract runs out. (How many insurance policies have you taken out which have lasted forever once you've paid your first and only premium?!). For example, the buyer of the option may wish to buy Newscorp at $15.00 at any time, up to and including the 30th June 2005. This date is known as the expiry date.
The premium is the amount that the buyer of the option pays for the option. The seller of the option keeps the premium regardless of whether the buyer wishes to exercise the option or not. What determines the premium (or price) of the option is examined later.
Finally the last key element of an option is: the type of option. An option is either a call option or a put option.
In the definition of an option, the word American was included within the words, "at or before a certain date..."
Options are either American or European.
A European option gives the option buyer the right (but not the obligation) to buy or sell the underlying asset at a certain price ONLY ON THE EXPIRY DATE.
We can now summarize the five key elements of an option.
Options are either traded as 'Exchange Traded Options' (ETO's) or 'Over The Counter' (OTC) options.
Over The Counter options - these are options where the two parties will negotiate all five key elements of the option. These 'tailor made' options allow both parties to create an option to exactly suit their requirements. OTC options can carry greater risk as it is often difficult to determine whether the counter party will be able to fulfill their obligation if required to do so. (Exchange traded options are often guaranteed by the exchange under which they are trading). If a trader no longer wishes to own the OTC option, it may be difficult to sell as the other party are not obliged to buy the option back and other traders in the market may not want a very specific, tailor made option. OTC options for Australian shares are traded almost exclusively between traders at investment banks.
Exchange Traded Options - most exchanges have preset 'key elements' giving each of the options specific assets, strike prices and expiry dates so that buyers and sellers don't have to negotiate these parameters every time they wish to trade. For example, the option buyer may just ring his broker and ask to buy a Newscorp, $15.00, 30th June, 2005 call option. The buyer or broker does not have to ring another party and negotiate the individual terms of the option as this had already been set by the exchange. They only have to determine whether or not another party wants to sell a Newscorp, $15.00, 30th June, 2005 call option. These options usually represent a certain number of shares, for example, in Australia one option usually represents 1000 shares. (If a trader were to buy ONE of the aforementioned options, it would give them the right but not the obligation to buy 1000 Newscorp shares for $15.00 at any time up to and including the 30th June 2005). If an option is trading at 17 cents, then the amount paid for the 'one lot' would equal 17 cents*1000 = $170.00. An advantage with Exchange Traded Options is that it is not necessary to record the counter party with whom the initial transaction was performed as the option trader is actually dealing with the clearing house (part of the options exchange). Therefore, when closing an option position, that is, selling a bought position or buying back a sold position, a trader can just sell the option on the market and have no further obligations. This is known as novation.
It was mentioned earlier that options are used either as a source of insurance to protect the value of the underlying asset or for speculators to try and profit by accepting this risk. However, you may have heard stories of people making or losing fortunes by using derivatives. Is this just the speculators trading with more money than they should, or is it something else? The truth is that derivatives allow far greater profits (and losses) with a set amount of capital (money) than if that same amount of capital was used to buy the underlying asset. This is where the concept of leverage is introduced.
Let's return to the example of the 'Newscorp, $15, 30/6/05, American, call option.' (If we bought this option we would have the right but not the obligation to buy Newscorp shares for $15.00 at any time up to and including the 30th June, 2005). Let us also say that Newscorp (the fully paid share, not the option) is currently trading at $20.00 and that someone is willing to sell us the aforementioned option for $5.00 (the option premium). Let's now move twelve months down the track to 30/6/2005 and Newscorp is trading at $25.00. If we have an option that allows us to buy Newscorp at $15.00, then surely our option must be worth $10.00? If it was worth less than this, someone could buy the option for $9.00 (say), exercise the option to buy Newscorp at $15.00 and then instantly sell the stock on the market for $25.00 making a risk free profit of $1.00. (This is known as arbitrage). This is where the leverage lies. If we had bought Newscorp shares for $15.00 and sold them for $25.00, our return is 67%. However, if we bought Newscorp options (bought at $5.00 and sold at $10.00), then our return is 100% on our initial investment.
Before you go selling all your quality stock and converting into options, let's look at how leverage works on the downside (there's always a catch!). If Newscorp shares were trading at $15.00 or less on the 30/6/2005 then our option would be worthless. Why would anyone want to buy an option which allows them to buy Newscorp for $15.00 when they can just go into the market and buy the shares for the same or less (say $14.00). Looking at the leverage again, if we had bought Newscorp at $15.00 and sold them for $14.00, we have made a loss of $1.00, or 6.7%. If we had bought the option, we would have made a loss of $5.00, or 100% of our initial investment.
| Share Price 30th June 2005 | Option Price 30th June 2005 | Profit on Shares | Profit on Options |
| $85.00 | $0.00 | -$20.00 (-19.0%) | -$10.00 (-100%) |
| $90.00 | $0.00 | -$15.00 (-14.3%) | -$10.00 (-100%) |
| $95.00 | $0.00 | -$10.00 (-9.5%) | -$10.00 (-100%) |
| $100.00 | $0.00 | -$5.00 (-4.8%) | -$10.00 (-100%) |
| $105.00 | $5.00 | $0.00 (breakeven) | -$5.00 (-50%) |
| $110.00 | $10.00 | $5.00 (4.8%) | $0.00 (breakeven) |
| $115.00 | $15.00 | $10.00 (9.5%) | $5.00 (50%) |
| $120.00 | $20.00 | $15.00 (14.3%) | $10.00 (100%) |
| $125.00 | $25.00 | $20.00 (19.0%) | $15.00 (150%) |
| $130.00 | $30.00 | $25.00 (23.8%) | $20.00 (200%) |
Using another example using larger numbers, the table shown gives a clearer idea of what is happening.
Say the Option premium (the price of the option) is $10.00 on 30th June 2004 and that the Stock price is $105.00 on the same date. The table shows prices of the same option one year later (30/6/2005) for different prices of Newscorp:
The table shows that the maximum loss associated with this investment is 10$ per option (100%). The maximum profit in this example, however, is 200% although the price of the underlying share has moved only 23.8%. Note also that the 'breakeven' price is different for the shares and the options.
| Share Price 30th June 2005 | Option Price 30th June 2005 | Profit on Shares (if we had short sold) | Profit on Options |
| $75.00 | $25.00 | $20.00 (-21.0%) | $15.00 (150%) |
| $80.00 | $20.00 | $15.00 (-15.8%) | $10.00 (100%) |
| $85.00 | $15.00 | $10.00 (-10.5%) | $5.00 (50%) |
| $90.00 | $10.00 | $5.00 (-5.3%) | $0.00 (breakeven) |
| $95.00 | $0.00 | $0.00 (breakeven) | -$5.00 (-50%) |
| $100.00 | $0.00 | -$5.00 (-5.3%) | -$10.00 (-100%) |
| $105.00 | $0.00 | -$10.00 (-10.5%) | -$10.00 (-100%) |
| $110.00 | $0.00 | -$15.00 (-15.8%) | -$10.00 (-100%) |
| $115.00 | $0.00 | -$20.00 (-21.1%) | -$10.00 (-100%) |
| $120.00 | $0.00 | -$25.00 (-26.3%) | -$10.00 (-100%) |
We have to stand on our heads somewhat with put options because if we buy a put option then we are profiting from a fall in the value of the underlying asset. This is because we are 'locking in' a higher sell price and the more the asset value falls, the more our option contract is worth.
Let's have a look at another example: We by a 'Newscorp, $100, 30/6/2005, American, PUT option,' on the 30/6/04 for a premium of $10.00. The stock is trading at $95. (If we bought this option we would have the right but not the obligation to sell Newscorp shares for $100.00 at any time up to and including the 30th June, 2005).
NB. We are assuming that if instead of buying a put option, we could have 'short sold' the share. Short selling is a transaction where a trader may sell the share (or asset) with the obligation of having to buy it back (hopefully at a lesser price) at a later date. In this case, we would have sold Newscorp shares on the 30/6/04 at $95 and will profit if the share price is less one year later. Please also note that some shares cannot be 'short sold'.
Again, we see that the maximum loss associated with this investment is $10 per option or 100%. The maximum profit in this example, however, is 150% although the price of the underlying share has moved only 26.3%. Note also, that the 'break even' price is again different for the shares and the options.
In previous examples, we saw that the share price had to move further in the direction of profit for the option to break even. This is because of the initial cost of the option.
What if we are selling (granting/writing) the option? Is it still possible to make large profits (or losses)? We saw that by buying an option (call or put) it is possible to make almost unlimited profits. It all depends on how far the underlying stock moves. We also saw that the most we can lose is our initial investment. That is to say, we cannot buy an option and have unlimited loss. This, however, is NOT the case when selling an option.
The seller of an option keeps the premium no matter whether the buyer exercises or not, but is obliged to fulfill their side of the contract if the buyer chooses to exercise.
Option sellers may enter a trade 'covered' or 'naked'. In the case of selling a call option, a covered position means that the call option seller already owns the underlying share. If the seller enters the trade naked, it means they don't own any of the underlying shares and their loss is unlimited. In the case of selling a put option, by entering the trade covered the seller already has the money to buy the underlying shares at the agreed price if the buyer wishes to exercise. If the seller enters the trade naked, they are at risk of facing unlimited losses because they are obliged to buy the shares at an agreed price but may only be able to sell them again at much lower prices.
Investors also know that selling options can increase the yield on their assets. For example, if we already owned Newscorp shares, then we could sell the Newscorp call option and keep the $10.00 premium. If the option is exercised (the option buyer wishes to buy Newscorp for $100.00) then we don't need to go to the market to buy it at a higher price as we already own the share. In other words, our only real loss is that if we had not sold the option, we would have been able to sell the share for a higher price one year down the track.
If we are bullish on the market, selling a put option may often be more profitable than buying a call option. In this particular case, it could be that the put option market for that particular asset is more liquid* than the call option market. Either way, we are looking for the underlying asset to move in the same direction. It should be noted though that the risk profile for these two trades is completely different.
Liquidity is a term that describes how easy it is to buy into and sell out of an asset. It is determined by the number of buyers and sellers there are for a particular asset. For example, a share might be very illiquid if it rarely trades, the highest buyer is at $1.00 and the lowest seller is at $1.35. In this case, if we wanted to buy the share and later we decided to sell, we may have to face a large loss (even though the company value may not have changed) simply because of the lack of liquidity. The trader may also face problems if they wanted to buy or sell a large amount of stock because a lack of other sellers and buyers may not allow a large order to be executed. Liquid stocks allow market participants to quickly enter and exit shares with large quantities.
| Share Price 30th June 2005 | Option Price 30th June 2005 | Profit on Options |
| $85.00 | $0.00 | $10.00 |
| $90.00 | $0.00 | $10.00 |
| $95.00 | $0.00 | $10.00 |
| $100.00 | $0.00 | $10.00 |
| $105.00 | $5.00 | $5.00 |
| $110.00 | $10.00 | $0.00 |
| $115.00 | $15.00 | -$5.00 |
| $120.00 | $20.00 | -$10.00 |
| $125.00 | $25.00 | -$15.00 |
| $130.00 | $30.00 | -$20.00 |
Consider the following example: If we sell the 'Newscorp, $100, 30/6/2005, American, call option'. If we sold this option we would have the obligation to sell Newscorp shares for $100.00 at any time up to and including the 30th June, 2005 if the option buyer chooses to do so. We sell the option for $10.00 on 30/6/2004 and keep this premium no matter what happens.
The table shows the profit/loss we make in one year's time.
We can see from the table that when the share price closes beneath $100.00, the buyer obviously will not exercise the option to buy Newscorp at $100.00. Therefore, the profit is simply the option premium. However, if the share closes at $105.00 (say) then the buyer will exercise and ask for the stock. As the option seller, we then have to go into the physical market (the share market, not the options market) and buy Newscorp for $105.00, only to instantly give it back to the option buyer for $100.00. Worse still, if Newscorp goes to $130.00, we have to buy Newscorp at this price and instantly sell them to the option buyer for $100.00, a difference of $30.00. The only thing to offset this loss is our $10.00 premium. As you can see, by selling a call option, there is unlimited loss if the underlying asset continues to rise. Imagine the panic amongst traders who have sold call options when there is a company takeover!
| Share Price 30th June 2005 | Option Price 30th June 2005 | Profit on Options |
| $75.00 | $25.00 | -$15.00 (150%) |
| $80.00 | $20.00 | -$10.00 (100%) |
| $85.00 | $15.00 | -$5.00 (50%) |
| $90.00 | $10.00 | $0.00 (breakeven) |
| $95.00 | $5.00 | $5.00 (-50%) |
| $100.00 | $0.00 | $10.00 (-100%) |
| $105.00 | $0.00 | $10.00 (-100%) |
| $110.00 | $0.00 | $10.00 (-100%) |
| $115.00 | $0.00 | $10.00 (-100%) |
| $120.00 | $0.00 | $10.00 (-100%) |
The situation with selling put options is similar, with the loss being extremely high with the underlying asset falling in price. As the share price falls, the option seller still has to buy the Newscorp shares from the put option buyer at $100.00. The option seller would then only be able to sell the shares at a lower price.
Again, we can see from the table that when the share price closes above $100.00, the buyer obviously will not exercise the option to sell at $100.00. Therefore, the profit is simply the option premium. However, if the share closes at $95.00 (say) then the buyer will exercise and sell the stock. As the option seller we are obliged fill this request. As you can see, the seller of put options is exposed to a very large loss if the underlying asset continues to fall. (However, the loss is limited by the fact the price of the underlying asset cannot fall below zero ($0.00)).
We have now seen that there are four possible trades that may be taken in the options market.
The table shows why a speculator or 'hedger' would carry out these trades
| Speculator | Insurer (hedger) | |
| Buying call option | Hopes to make rapid profits from increase in underlying asset price | Has money to invest sometime in the future. Buys call option to 'lock in' today's price in case price of underlying asset increases. (Profit on options will offset extra money to be paid for shares in the future but any loss on options only means purchasing the shares at a cheaper price in the future). |
| Buying put option | Hopes to make rapid profits from decrease in underlying asset price. | Already owns the shares over which the put option is being purchased. If share falls in value, this loss is offset by the gain in value of the put option. Any gain in value of the asset corresponds with a loss on the option but the insurer is 'locking in' is then able to sell the shares at a higher price in the market. |
| Selling call option | Will keep the premium and hopes that the buyer of the option will not wish to exercise. Hopes for value of underlying asset to fall. | Will already own the shares and is trying to make extra money out of selling call options against it. Only downfall is that the call option seller 'caps' the selling price of their shares and by doing so, possibly missing out on more profits. |
| Selling put option | Will keep the premium and hopes the buyer of the option will not wish to exercise. Hopes for value of underlying asset to rise. | Already has the money to buy the underlying asset at a set price (in case asset value falls) but is trying to make some extra money by selling options beforehand. If price falls it just means they could have bought the asset at a cheaper price. |
So we have seen that we use options to:
You should now have a basic understanding of options and warrants. In the next section, we clarify some of the option 'payoffs' by using diagrams.
Payoff diagrams are very common when discussing options. A payoff diagram simply shows what the value of the option is (shown on the vertical axis) for different prices of the underlying share (shown on the horizontal axis) at a particular time in the options life (nearly always shown at the options expiry).
We will now look at a few examples of payoff diagrams, starting with a payoff diagram for a single call option.
The first diagram shows the payoff for a $1 call option (that was bought for 10 cents) on a share at expiry.
We see that if, at expiry, the share price is below $1, then the option buyer has 'negative' payoff (because the payoff line is below zero on the vertical axis). The amount that the option buyer has lost is naturally the premium of the option that the buyer paid at purchase. In this case, the buyer paid ten cents (say three months ago).
We can also see that the buyer neither makes a profit or a loss when the underlying share price is at $1.10. This is because the option is worth 10 cents at expiry and this negates the 10 cents paid for the option three months ago. This point, where the payoff line crosses the horizontal axis is known as the breakeven point.
The option buyer makes money from the option when the underlying asset has values greater than $1.10.
The party that sold this option has a mirror image (around the horizontal axis) of this payoff. The seller retains the premium for the option and this is seen for values of the underlying asset (horizontal axis) below $1.00 where the option is worthless at expiry. The breakeven point is still at $1.10 but above this value, the option seller has unlimited loss and this is shown in the payoff diagram.
Diagrams for the buying and selling of a put option are shown here.
The situation is the reverse to that of the call option: If the share price is above the strike price at expiry, the option buyer has 'negative' payoff (because the payoff line is below zero on the vertical axis). The amount that the option buyer has lost is naturally the premium of the option that the buyer paid at purchase. As the price of the underlying asset falls, the seller's profits grow.
The party that sold this option has a mirror image of this payoff. The seller retains the premium for the option for values of the underlying asset (horizontal axis) to the right of slope, where the option is worthless at expiry. As the price of the underlying asset falls, however, the seller's losses mount.
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| The first figure shows a Call Spread: We have bought call options and sold call options with a higher strike for the same underlying asset | The second figure shows a Put Spread: We bought put options and sold put options with a lower strike for the same underlying asset |
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| The Long Straddle produces a 'V' shaped payoff curve. We bought call and put options with the same strike price | The Short Straddle produces an inverted 'V' shape. We Sold call and Sold put with the same strike price |
What if we had two different options, with the same underlying asset and expiry date? What kind of payoff diagram will this produce? The resultant payoff diagram is simply the sum of the two separate payoff diagrams. Some of these strategies are here:
(NB. There is often more than one way to create a strategy)
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| Long Butterfly: 1 Bought call A, 2 Sold calls B, 1 Bought call C | Long Butterfly: 1 Sold call A, 2 Bought calls B, 1 Bought call C |
Butterflies are produced when we buy combinations of three options. The first figure shows a long butterfly. To produce this butterfly, we add up the payoffs from call options bought at A, call options sold at B (with a higher strike price) and call options (of yet a higher strike) bought at C.
To produce a short butterfly, we would have to sell call options at price A, buy call options at price B and sell call options at price C.
So, how much should a trader pay for an option? What is the 'fair value' of an option? This question of fair value has been the subject of much debate since the inception of options. Before embarking on finding a solution to the problem, it is important to know what factors influence the price of an option.
In 1973, Merton Scholes and Fischer Black came up with a formula that still forms the basis of most pricing formulas today. It combines the following factors to calculate an option's price
We will briefly cover each of these factors in the following slides.
Underlying asset: Usually, the main factor to consider when pricing an option is the value of the underlying asset. The higher the value of the underlying asset moves, the more the value of a call option increases and a put option decreases.
Strike Price: The second aspect to the price of the option is the strike price. The higher the strike price, the less valuable a call option will become and the more valuable a put option will become.
Time to expiry: The longer the time until expiry, the more valuable both a put and a call option become. Taking a simplistic view, this can be put down to the buyer having more time in which to make money on the option and more time for which the seller has to take the risk of being exercised.
A more scientific explanation can be found by looking at cash flows. Say an investor wishes to buy 1000 BHP shares in 1 year's time. He either has the choice of buying the stock on market or buying 1 BHP call option expiring in one year's time. If the investor buys the stock then they have no cash left. If they buy the option (the premium being a lot less than the full value of the stock) then they will have left over money with which they can put in the bank and earn interest. The longer the investor has to put the extra cash in the bank, the more valuable that option will be. This process of not having to pay the full amount of money for the underlying asset and being able to reinvest the extra cash brings us to the next factor in pricing an option.
Interest Rates: From the previous explanation it follows that the more money that the extra cash (from buying the option and not the stock) can make, the more valuable the option will become. If the surplus cash can be invested at a rate of 10% instead of 5% then the option will be worth more. Therefore, for a call option, increasing interest rates will increase the value of the option.
But what about put options? The value of a put option actually decreases with a rise in interest rates. This is because investors would rather sell stock now (to get the cash in the bank) and therefore have little use for a contract allowing them to sell stock in the future.
Dividends: An important thing to remember with options is that the option holder is generally not given the same entitlements as a party holding the underlying asset. For example, an option holder on a stock is not entitled to dividends. The higher the dividend rate, the less the value will be of the call option because an investor could be getting a higher return if they bought the underlying share instead of the call option. Because the share price will fall after the stock has paid a dividend, the higher the dividend, the more valuable a put option will become.
Volatility: Now we introduce the concept of volatility. As the name suggests, volatility refers to how much the underlying share moves around. Why should volatility be so important? The answer lies in potential reward that the option buyer may receive and the potential risk that the option seller takes. If a $10 stock had a trading range over a year of 50 cents (say a high of $10.25 and a low of $9.75) then someone selling a $10.50 call option is not taking as much risk than if that stock had a trading range over the year of $8.00 (say a high of $14.00 and a low of $6.00). Likewise, a person buying an option on the first $10.00 stock would not have as much chance as making money than if they bought an option on the second $10.00 stock. This difference will reflect in the options price. That is, the initial $10.00 stock option will have a lower premium than the second option. To summarise, the more volatile the stock, the more expensive the option will be (for both put options and call options). Mathematically, by using Strike Price, Time to Expiry, Interest Rates and Dividends, we can calculate a 'fair value' of the option fairly easily. However, the formula becomes far more complex when we introduce the concept of volatility.
In 1973, Merton Scholes and Fischer Black came up with a formula that still forms the basis of most pricing formulas today. The 'Black Scholes' formula is shown here
From this rather complex formula, it can be seen that the calculation of a fair value is a very difficult process. Even the Black Scholes formula has many pitfalls and many refinements have been added over the years to try and eliminate these problems. Knowledge of the formula is certainly not a prerequisite to trading options but it has been included here to demonstrate that there exist methods of approximating a fair value for an option. Computer software exists that allows the user to enter the various parameters that make up the formula and the fair value is calculated.
The spot price of the underlying share, time to expiry of the option, dividend yield of the underlying share and interest rates are easily found and entered into the equation. But how is volatility calculated?
Remember, volatility is a measure of how much the stock moves around an average price. Mathematicians may recognise this as the standard deviation: the average distance something moves from the mean. The mathematics for calculating volatility has not been included here but it is sufficient to say that methods for its calculation are well established.
By seeing the price of options on the market, option traders can work back through a formula to calculate the implied volatility of that option. If the trader thinks that the implied volatility is undervalued, that is, they think the volatility of the underlying asset is going to increase, they may buy that option. It is important to note that historical volatility may have nothing to do with future volatility. (This is similar to a stock where past movement may not give any clues to the future movement of the stock).
This has been a very basic introduction to the pricing of options and is only intended as a rough guide to what influences the value of an option. Readers should note the numerous pitfalls of using an options pricing formula. To close this lesson, we take a brief look at other types of derivatives.
Variations in warrants exist and are outlined below.
Installments: Installment warrants work differently to the plain 'vanilla' options and warrants that have been described so far.
With installments, an initial payment that makes up a portion of the current share price is made to a third party (the issuer of the installment). This payment allows the investor to participate in a full share of dividends (with any franking credits), gives exposure to share price movement and gives the holder voting rights. A second payment is made 12 to 18 months later (usually) at which time the installment becomes a fully paid share. Installments can usually be bought direct from the issuer (at time of issue) and this can often have tax advantages. Installments also usually have a secondary market allowing the holder to sell the installment and their obligation to make the second payment along with it.
Endowment warrants: These types of warrant allow long term investors to pay 30% to 50% of the market value of a share now and pay the remainder (based on today's share price) at some time in the future (usually around ten years). There is naturally an interest rate component built into the endowment price but the amount outstanding is reduced by dividends and franking credits (where applicable). The outstanding amount paid at expiry is therefore a variable amount. There is usually a secondary market for the endowment warrants allowing holders to sell their endowment at any time up to the maturity date.
We see that the options market is as diverse as the market from which it 'derives' its price. Options and warrants can provide a simple way to gain leverage or increase yield or provide a complex forum from which to seek profit from such things as volatility arbitrage. However you view the options market, it is an exciting market that continues to gather popularity among institutional and retail traders alike.
Contracts For Difference (or CFD's) are one of the fastest growing financial products in the world today. With these types of derivatives, the derivatives buyers will buy the CFD from a market maker at the prevailing market price. The only money outlayed by the buyer is a small proportion of the total value. When the buyer sells, the market maker will pay them the difference (if the buyer made a profit) or ask for money from the buyer (in the case of the loss) from the initial purchase price.
A more in depth study of this exciting product is given in the following lesson on CFD's.