Change In The Price Of Options Premiums example essay topic

Options and the Investor Most people know that an option is a choice. It is a choice to buy that new compact disc, a choice to upgrade to leather on a new car, or a choice to speculate in the market. Options are a way to reduce risk associated with trading stocks and are quite advantageous in a capitalist society. An option is a "contract between two parties to purchase or sell a commodity futures contract at a predetermined price within a specific time period.

Every option transaction has an option buyer and an option seller (4, p. 236)". The advent of organized options trading by the Chicago Board Options Exchange created a new way to play the market. Options can be used to hedge risk and to take profits larger than would be possible by buying and selling stock. This result can be accomplished using a variety of combinations to be discussed later in this paper. These strategies can be useful as pertaining to the options trader who wants to make the most profit with the least amount of risk. Elementary pricing of options will help the reader in understanding some of the differences in premiums and why the differences are so large.

The Chicago Board Options Exchange has changed the way that options are traded through advances in technology to the point that options are bought and sold instantaneously with almost a 100% guarantee of credibility. This is one of the main reasons for the options explosion. Options Basic options have existed for eons and have been used as investment strategies for thousands of years. The concept was definitely used by societies other than ours, as illustrated by this excerpt from Aristotle's Politics (2, p. 16): There is an anecdote of Thales the Milesian and his financial device, which involves a principle of universal application, but is attributed to him on account of his reputation for wisdom. He was reproached for his poverty, which was supposed to show that philosophy was of no use. According to the story, he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive presses in Chios and Miletus, which he hired at a low price because no one bid against him.

When the harvest time came, and many wanted them all at once and of a sudden, he let them out at any rate that he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like... As one can infer from the quote, Thales used his knowledge to speculate that the olive harvest would be bounteous and invested in the presses that would be in such great demand at harvest time long before anyone else bothered to think about it. In other words, he purchased a long put on the olive press market. These terms will be explained in the paragraph to come, as there are many terms necessary to understand the complex nature of options and how they work.

Options Terms Due to the complex nature of stock and index options in the market today, it would be helpful to the reader to go through some of the major terminology before attempting anything else. Less than thirty years after officially being introduced to the market, options trading strategies have evolved into complex hedges: hedges on stock indexes, on interest rates, and any number of arrangements to produce the most profit with the least risk. To begin with, there are two basic kinds of options: a call option or a put option. A call option consists of the right to purchase the underlying good at a specific price lasting a specific amount of time; a put option consists of the right to sell the underlying good at a specific price lasting a specific amount of time (1, p. 2).

The buyer of the call is the person who purchases a contract with the option to buy a certain stock at a certain price in a specific time window. He purchases this right from the call seller or call writer who agrees to sell his stock to the call owner at that price for that amount of time. This price in known as the exercise or strike price, and it does not change. One determines the price of the option, known as the premium, by the exercise price and the volatility of the stock. The same is true with the owner of the put option. He purchases the right to sell the underlying good at a specific price for a set amount of time.

The put seller receives the purchase price and agrees to buy the underlying good at the exercise price, if the put owner so chooses. Basically, options-trading strategies boil down to speculation on whether a specific good in the financial market will rise or fall in price and how large a fluctuation will occur in the overall price change. Many investors believe that it is possible to predict the path of a stock or index in the future - a belief that leads them to the desire to purchase options on the specific stock, index, or interest rate with these predictions in mind. A person might wonder why there is so much attention paid towards options when they were only brought out publicly less than thirty years ago. This question is a valid one for those who do not understand the options game.

To those who do, there is a very simple answer. 1. Options can be used to reduce risk almost to zero. 2. Options can promise consistent and high profit return, without the need to predict action in the market. 3.

Options can be a trading medium that, if applied properly, will provide a positive, consistent return (3, p. 6). This may sound like a no risk situation, but these rules only apply to the trader who has a strong grasp on the options trading strategies that dominate so many pieces of economic literature. Keep in mind that for every dollar one investor makes in the options market, there is an investor who loses that same dollar. The amount of money that goes in the market is the same as the amount that comes out of the market. A couple of examples of trading strategies may allow for a better understanding of options on the whole and how they can benefit the investor more than the simple act of buying a stock. Options Pricing As written before, the price of an option premium is determined through a series of mathematical derivations that represent one particular pricing model or another.

In these models, volatility is a major determinant of premium price. "All option models depend heavily on the calculation of volatility in determining the fair market value of an option. It is defined as "the measure of price changes in an option's premium" (4, p. 27). Investors want to purchase options which have the greatest chance of movement, in order to give them the greatest chance of realizing profits. Just as low volatility accounts for a correspondingly lower premium, high volatility in any stock, index, or future will drive up the premium for that product.

Volatility calculations come from historical volatility and implied volatility. By averaging a past series of option prices (30 day set, 90 day set, etc... ) historical volatility of options can be calculated. Each different set of price histories can be used for different purposes, depending on the investor's desire. Implied volatility is calculated using a number of different things.

Commodity price level, time to expiration, interest rate, and the most current option prices all contribute to its calculation. "This method provides a more accurate picture of the current volatility of an option, compared to the historical volatility which is a smoothing of past price action (4, p. 37). The odds are better than 65% that the market will stay inside the calculated range of volatility over a one-year period (4, p. 36). Value of options premiums also depends on a variety of things besides volatility: strike price, expiration period, interest rates, and supply & demand. Strike price is quite important in determining the value of an option. When one terms an option "in-the-money", the option has intrinsic value (4, p. 21).

For instance, if an investor owns a call option with a strike price of $80 and the current value of the stock itself is $90, the investor could exercise his call with price $80 and make a $10 profit from his move. Intrinsic value is defined as "the amount of money that could be realized if the option were to be exercised immediately (4, p. 236)". In-the-money options are the only types that are said to have intrinsic value. Out-of-the-money options are ones that have no intrinsic value. The striking price of these options is always higher than the actual price of the stock, which means that the investor would lose money if he exercised his option to buy. This leaves the reader to ask; why would one buy an out-of-the-money call?

The answer to this question is time value. The expiration date also has a lot to do with the price of an option premium, especially when the time of expiration is thirty days or less away. The drop in the price of a premium immediately before the options contract expires is known as time value. Time value is defined as "the amount by which an option premium exceeds the option's intrinsic value" (4, p. 237).

To elaborate, time value is the term to describe any change in price over a certain period of time. An investor may buy an out-of-the-money call with an expiration date three months from now because he expects the stock to rise for one reason or another over the course of the next couple of months. The time value is the actual change in price during this time period. However, time value is not constant. "All options contain time value up until the day they expire. However, this time is constantly eroding, causing the time value of the option to decline" (4, p. 26).

Decay of time value is an exponential function that increases in magnitude as the expiration date of the contract gets closer. Also, changes by the Fed can cause a change in the price of options premiums. Interest rate is another viable component of the price determination methods we use. This occurs due to less or more investment opportunities that arise out of a change in the interest rate. If the Fed raises the rate, option premiums fall to make them more attractive. When alternative investment opportunities look better to investors, less money is bid for option premiums - an act that causes premiums to fall and the rates of return to rise.

The last factors to be discussed are supply & demand factors. These factors arise when a market is "Trending" towards one particular product (4, p. 28). An example of this would be crude oil options during the Gulf War. As granters were reluctant to sell their positions in this market because of its popularity at that time, the supply of options to be sold went down.

This caused the price of the premium to rise with the demand for crude oil options. It may be helpful to get a feel for the medium in which options are most heavily traded. This medium is located in Chicago, and is known as the Chicago Board Options Exchange, founded by the Chicago Board of Trade. Prior to the advent of the Chicago Board Options Exchange, options were traded unofficially, and were unregulated by any national standard. This made options investing quite risky and kept many conservative investors away from the market. Options advanced in ease of trade when the Chicago Board Options Exchange offered its first sixteen stocks for trading in April of 1973.

The Chicago Board Options Exchange The true options revolution came about when the Chicago Board Options Exchange, also known as CBOE, began trading call options on 16 stocks in April of 1973. Created by the Chicago Board of Trade, CBOE has always been managed as a separate entity (5). The SEC placed a moratorium on options trading in 1997, and by the time their review was complete, great improvements had been made in the area of customer protection. In 1980, after the moratorium ended, the CBOE increased the number of options on listed stocks up to one hundred and twenty. Just three years later, on the tenth anniversary of the opening of the exchange, CBOE began trading options on broad based stock indexes by incorporating the Standard & Poor's 100 Index into its trading.

It has become the most active index product on the market. Today, CBOE trades the S&P 500 index as well. It may be helpful to now go through some of the steps necessary for a trade to take place and who is involved in this. If you the investor decide that you want to purchase a call or put option, you might pick up the phone and call your broker, who then places the order, usually through a DPM (Designated Primary Market Maker).

This process is the facility through which a majority of the trades take place. The DPM is the designated firm by the exchange to keep orders routine. The floor broker then receives your trade order, executes it, and enters it into his hand held computer, which sends it back to your broker's booth. You the investor will then receive the information regarding your trade. When it was evident that CBOE was catching like wildfire, construction on a facility for CBOE trading alone began, and CBOE moved into its own building in 1984. The trading floor alone is 45,000 square feet, with an identical floor in reserve for future possible use.

The 4,500 computer terminals comprise the world's largest collection under one roof. Technological advances have made it possible to trade on the floor quicker than ever. "The CBOE Order Routing System currently handles more than 85 percent of public customer orders. In addition to order routing technology, CBOE has maintained visionary growth on the trading floor. Many market makers that previously used hand written cards to facilitate trades, now trade with the assistance of 19 oz hand-held computers. Huge data walls align segments of CBOE's 45,000 square foot trading floor, providing entire index pits with real time, dynamic trade data.

Re-configurable display screens (RCN) are abundantly placed in equity trading crowds and display real time trade data, even from multiple exchanges" (5). CBOE's seven-story building has enough cable to serve a city of 200,000 people. 4,060 telephone lines and 947 telephones service the trading floor. Another technology created through CBOE is RAES. The Retail Automatic Execution System, or RAES, which gives retail customers with certain premium and size levels the fastest degree of order execution possible, was developed exclusively for use on CBOE. This system almost guarantees that the price at which the order was placed will be the same as when the order is executed.

Today, almost 30% of retail customers use RAES, including market makers. RAES even rejects orders having a lower posted price on a different exchange! The addition of the PAR (Public Automated Routing) system is one of many other advances the CBOE has developed. PAR represents the determination of CBOE to remain on the cutting edge of technology. PAR is a touch screen system with a PC base which determines order routing and execution on the floor. Once the floor broker executes an order, the customer and OPRA receive a fill report and sale information, respectively.

Here the OPRA transmits this data to vendors worldwide (5). As one can see, technology is outpacing itself at CBOE. The amount of money transferred from day to day supports these advances and explains why so much attention is paid to speed of execution of orders. The CBOE has introduced many modified options trading strategies: options on interest rates (1989), LEAPS (1990), FLEX options (1993), and sector indices (1992). Options on interest rates simply allow the investor to bet on where interest rates will move and to hedge interest rate exposure. LEAPS have opened a new way to trade options, especially for those investors suited for conservative trading.

"LEAPS are long term options in equity, index, and interest rate classes that allow investors to establish positions that can be maintained for a period of up to three years". Because of the long-term expirations and because of the similarities between LEAPS and shares of stock, LEAPS are quite helpful (10). FLEX (Flexible Exchange) options allow large-scale investors to mold the options contract, although there is one catch. The minimum opening underlying contract must have a value of 10 million dollars. Options Trading Strategies Many different strategies associated with options trading exist, ways which help to reduce the amount of risk associated with trading. Hedging your bets is a way to counteract possible heavy losses if a venture on a stock fails.

"A straddle consists of a call and a put with the same exercise price and the same expiration" (1). Buying a straddle involves buying both a put (option to sell) and a call (option to buy) on the same stock. With this strategy, the investor believes that the stock will change in some drastic way but is unsure whether the change will be positive or negative. The only drawback is the added premium that must be paid offsets total profits. The only risk is the loss of the premiums if the stock does not move significantly in one direction or the other, but by hedging the bet, the investor stands to lose significantly less than he would had he simply bought a put on a stock that proceeded to go through the roof in value (2).

Selling a straddle is the exact opposite. The investor is betting that the stock will not move significantly in either direction. Even if it does, he has taken the necessary precautions to ensure that he does not lose the farm. Fact: markets move in cycles. The smart investor can use his knowledge of these cycles to make money with less risk through the use of options. The "bull" and "bear" strategies have evolved as a way to profit using information regarding present trends in any market or stock (1, p. 43).

Obviously, the bull spread uses a combination of options to profit from a rise in price. The strategist sells a call option at an exercise price above the current price of a stock and buys a call with an exercise price below the current price of the stock. This way, he profits as long as the stock goes up and cannot lose nearly as money as would be possible were he to simply buy the stock to see it go down. It is true that he could make more money if he bought the stock and it went up, but the risk is much lower if he uses this strategy. The "bear" strategy simply reverses this idea. The trader sells a call with an exercise price below the current value of the stock and buys a call with an exercise price above the current value.

The bull and bear strategies simply mirror each other. Arbitrage Arbitrage is known as trading to make a risk less profit with no actual investment. Common arbitrage includes finding two different prices for the same stock in different markets. If an investor finds stock DEF on the American Stock Exchange for a lower price than on CBOE, then he will buy shares on AMEX while he sells shares on CBOE. This act involves no real investment if the trade is executed precisely. If precise, the investor sells stock on CBOE at the same time he buys it on AMEX.

In a smoothly functioning market, arbitrage does not exist for long, for the increased demand for shares on AMEX and the increased supply of shares at CBOE will cause the prices to balance out eventually. The arbitrageur is the investor who tries to spot these momentary fluctuations and use them to his benefit. The arbitrageur uses different modes to try to find these disparities. Some use elaborate calculations while others use their intuitive feel for the market developed by lots of experience. The Clearinghouse The Options Clearing Corporation (OCC) uses its name credibility to ensure that all transactions at the end of the day are traded in full. It is a way for the individual investor to remain confident that the person with whom he is trading will not try to back out of a deal arranged before.

For instance, if the seller of a call of a stock that went up dramatically is unwilling to part with the share (s) at the lower agreed-upon price, the purchaser of the call needs a way to make sure his position is secure without having to deal directly with the seller. This is where the OCC steps in. At the end of each day's trading, the OCC matches all of the trades between the buyers and sellers of calls and puts. If the buyer's records match those of the seller's, then the trade is a matched trade, and everything proceeds accordingly.

This process is known as clearing and is the primary purpose of the OCC. Every options trade must be cleared for the market to run smoothly. In a way, the Clearinghouse acts as a guarantor to both sides of every transaction. It takes responsibility for making sure that every trade is executed properly. This basically endows every single investor with the credibility of the OCC, which gives much more confidence to the individual investor pondering entrance to the options market.

In this way, if a trader defaults on a contract, the OCC absorbs the loss created by the defaulter and takes action against him (1, p. 13). Keep in mind that the OCC is merely a watchdog. It has a net position of zero in the market it helps to regulate. The average investor does not know how options work and therefore, does not bother with investing through them. The evidence presented in this paper charges every informed investor to investigate and decipher the secrets of trading options.

It is shown in the pages preceding that using options to hedge investment risk, or using options alone can almost eliminate the chance to lose big when investing. Accomplished strategists have done very well in the options market, because with an increased repertoire of investing strategies, the investor who balances risk with reward will have the most success trading options.

Bibliography

1. Kolb, Robert, Options; An Introduction, (Miami, FL: Kolb Publishing Co., 1991).
2. Gatineau, Gary, The Options Manual, 3rd Edition (New York, New York: McGraw-Hill Book Co., 1988).
3. T rester, Kenneth, The Compleat Option Player, 4th Edition (New York, NY: Inves Trek Publishing, 1984).
4. Caplan, David L. The New Options Advantage (Chicago, IL: Prob us Publishing, 1995).