As early as 1000 B. C. , we can see an early sign of options. According to the Fundamentals of Corporate Finance, Thales the Philosopher knew from the stars that there would be a great olive harvest. Thales did not have much money, but was able to purchase options for the use of olive presses. When the harvest arrived he was able to rent the presses at a substantial profit. Thales speculation on the harvest allowed for him to purchase rights to the presses. He could then exercise his rights if his speculations on the harvest were correct.
An option is a contract giving the buyer the right to buy or sell an asset at a specific price for a limited time. An option is a contract between the buyer and seller with defined parameters. The asset that is bought or sold is called the underlying. This underlying asset could be a commodity, a futures contract, or stock. The seller gives the buyer the rights for a sum of money called a premium. The price that the underlying right is bought or sold at is called the exercise price. The two types of Options are Calls and Puts.
When an option gives the buyer the right to purchase underlying assets from a writer is called a call option. The call option is the most straightforward strategy for capitalizing on an anticipated increase in the price of the underlying asset. The investor that buys a call option is said to be in a long call position. An investor that believes the price of an underlying asset will decline or remain the same, can if his speculations are correct, realize income by selling a call option. The seller is said to be in a short call position.
When the purchaser of an option has the right to sell the underlying asset the option is called a put option. With a put option you can insure an asset by locking in a selling price. If the price of the underlying falls you can exercise your option and sell it at the locked in price. If the price of the underlying asset increases then you would not exercise your right and the only cost incurred is the premium paid for the option. The investor that purchases a put option is said to long put position.
The investor that can earn income buy selling a put is said to be in a short put position. The people that buy options are called holders where those that sell options are called writers. The holder of a call has purchased the right to exercise a call. Put holders have purchased the right to sell the underlying asset at the locked price. However, neither the call holders nor put holders have an obligation to exercise their rights on the option. On the sellers side, call writers are required to sell the underlying asset when a holder exercises his right to buy.
Put writers are also obligated to buy the underlying asset at the locked in price. Options are traded on several different exchanges. The first of these is the Chicago Board Options Exchange founded in 1973. Other exchanges that options are traded on are the American Stock Exchange, The Philadelphia Stock Exchange, The Midwest Stock Exchange, and The Pacific Coast Stock Exchange. The key to the success of the options market is in the structure, which puts together two different types of transactions in one process.
These two types are: The creation of an option by writer and purchaser, and the secondary market where the investor has the opportunity to sell his position by canceling transactions through the exchange. The Buyer and seller are not the only entities in options trading. The Options Clearing Corporation is an intermediary between writer and purchaser as well as serves as an accounting office between them. The Options Clearing Corporation is the issuer of individual options. It takes the position of the writer for the purchaser, and takes the place of the buyer for the writer.
The OCC is responsible for making certain that the writer of a call always fulfill its obligation to the buyer if he exercises his option. This is how the OCC guarantees the financial stability of options transactions. The members of the OCC are made up of the brokerage houses and are accountable to the OCC for making sure that options transactions process smoothly. If an investor wants to exercise an option he calls his broker, who then notifies the OCC. The OCC then chooses a broker at random with which the corresponding option that has been sold.
When looking at the investor side of options trading it is important to look at how options are priced and valued. There are several aspect that have to be considered. The first is the fluctuation of the price because of the laws of supply and demand. The underlying asset in the option will fluctuate in price during the life of the option and this will cause the price of the option to fluctuate as well. Another aspect of the value/price is the time premium. A better measure of the time premium is the percent of time premium.
The time period per month of the time that is left makes up the percent of time premium. Speculation and trading amounts increase as the time period shortens and the open interest increases. This means that an options with a longer life, even though higher priced, will not have a greater percentage of time premium per month of life left than an option with a shorter life. The third aspect of price/value is the intrinsic value of an option. The intrinsic value of an option only exists when the underlying asset is worth more than the locked price on a call.
For example if an investor has the right to purchase a shares of xyz stock at seventy dollars and the price of the stock is seventy four dollars a share than the intrinsic value of the option is four dollars. So if the option is selling for seven dollars than the time premium is three dollars and the intrinsic value is four dollars. These are the three main aspects of pricing and valuation. One main reason for buying options, other than making a profit, is to reduce risk.
Portfolio Managers often buy options in order to reduce the down side risk of the portfolio. Options also could be bought to help limit potential market risk. For example, if a company made jet planes and they are concerned about the price of metals rising, they could purchase a call option and lock in a price. If the price of the metal goes above the lock in price they can exercise there right to purchase at the agreed upon price. If the price goes below the locked price they can just not exercise their right on the option.
All they lose is the premium. The same idea can be used for stocks. If an investor speculates that the price of a stock is going to rise then he could buy an option to lock in a price with the hope that the price will rise as speculated. If the price rises he could exercise his right to purchase the stock at a lower price. The investor could then sell the stock as a profit. Buying this option very much limited the amount that he could lose on the investment, and at the same time the amount of possible gain seams almost infinite.
The same idea can work on the sell side as well. If a company that sells oil speculates that the price of the oil will fall they can purchase a put option. This gives them the right to sell the oil at an agreed upon price so if the price of oil falls lower than the exercise price they will be able to sell oil at the locked price and realize a gain. Interest-Rate Agreements are another way that investors can control their risk. There are two types of these agreements a ceiling rate agreement and a ceiling/floor rate agreement.
In a ceiling rate agreement a financial institution providing the agreement will compensate the buyer for the difference of the actual rate and the agreed upon ceiling rate. So if the ceiling was 10% and the interest rate rises to 13% the financial intermediary will compensate the buyer the extra 3%. In a ceiling/floor agreement it is a little different. Usually the financial intermediary is trying to protect its earnings on lending. If the rate goes above the ceiling then the entity compensates the buyer, but if rates go below the floor then the buyer compensates the bank for rates under the agreed percentage.
Options appear to be extremely complicated so many investors dont like to use them. However, if understood they can be very useful. They are excellent tools for hedging and lowering risk as well as investments for profit. The option market allows for two types of transactions to be exercised at the same time; buying and selling the options and being able to sell the underlying asset holdings. The Option Clearing Corporation makes sure that these day to day option trading runs smoothly. These reason are why options are a good alternative to other security trading.
