Options: introduction

An option contract gives the holder the right (with no obligation) to buy or sell shares of a particular common security at a predetermined price (strike price) at or before a specific date (expiration date).

The option contract is designed as a CALL option when the holder has the right to buy... and as a PUT option when the holder has the right to sell...

The price paid for the option per share is called the premium. Then intrinsic value refers to the difference between the strike price and the stock price (for a stock option) and the time premium represents the value of option above the intrinsic value.

The underlying securities for the option contract, besides common stocks, can be indices, foreign currencies, US Government debt or commodities...
There are two styles of options:

• American style: the option can be exercised before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry.

• European style: the option can be exercised on the expiration day only and not anytime before that. Options usually act like European options

Options: valuation

Option valuation is a complicated business. With this short document, we give the main definitions and ideas without technicalities. Then, we limit this part to the valuation of the option contract at the expiration date.

Following the definition of the first part, the value is a function of the stock price and the exercise price.
Example: For an option with a strike price of 60$, we give the different CALL/PUT values depending of the "effective" stock price at expiration:

A short history of options

• Ancient Origins:

Although it is not known exactly when the first option contract traded, it is known that the Romans and Phoenicians used similar contracts in shipping. There is also evidence that Thales, a mathematician and philosopher in ancient Greece used options to secure a low price for olive presses in advance of the harvest. Thales had reason to believe the olive harvest would be particularly strong. During the off-season when demand for olive presses was almost non-existent, he acquired rights-at a very low cost-to use the presses the following spring. Later, when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent the equipment to others at a much higher price.

In Holland, trading in tulip options blossomed during the early 1600s. At first, tulip dealers used call options to make sure they could secure a reasonable price to meet the demand. At the same time, tulip growers used put options to ensure an adequate selling price. The end of this famous tulip bubble was not terrific.

However, it is interesting to observe that these (hedging) techniques are part of the business of modern companies, as Gold mines.

• Early Options in the US:

In the US, options appeared on the scene around the same time as stocks. In the early 19thCentury, call and put contracts-known as "privileges"-were not traded on an exchange. Because the terms differed for each contract, there wasn't much in the way of a secondary market.

Instead, it was up to the buyers and sellers to find each other. The Investment Act of 1934 legitimized options and put trading under the watchful eye of the newly formed Securities and Exchange Commission (SEC).

Leverage & hedge using options

Options have essentially two interests: they can be used to provide leverage with a speculative goal or they can be considered as an insurance to protect with a relatively small investment a large portfolio of stocks and bonds for example.

First, options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value. An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index.

Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment percentage loss. Hence, options allow investors to speculate about the future direction of prices of stock through investment of a relatively small amount of money.

Second, investors can use an option as an insurance to hedge a stock investment against great losses when adverse changes occur with stock prices. Losses at buying options are limited by the premium amount. This is what is usually labeled as "hedging": which means an option strategy that aims to reduce (hedge) the risk associated with price movements in the underlying asset by offsetting long and short positions.

Futures (short description)

A futures contract can be defined as an agreement between two parts in which they commit to exchange an asset, physical or financial, at an established price and at a future pre-established date at the signing of the resolution.

For the buyer, the contract of futures means the obligation of having to buy the underlying asset at a future price at the date of expiration and for the salesman, it supposes the obligation to sell such underlying asset at the future price at the same date of expire.

As you can see, it is very close to the option definition introduced above. In fact, it is not a surprise as both, options and futures, can be ranged under the concept of derivatives. Quite generally, a security whose price is derived from one or more underlying assets is called a derivative: obvious! Its value is determined by fluctuations in the underlying asset.

The main difference between futures and options, except some details in the dealing process, is related to the margin. In the futures market, margin refers to the initial deposit made on an account in order to enter into a futures contract. This margin is referred to as good faith because it is this money that is used to debit any day-to-day losses. When you open a futures contract, the futures exchange will state a minimum amount of money that you must deposit into your account.

This original deposit of money is called the initial margin. When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or losses that occur over the span of the futures contract. The minimum-level margin is determined by the futures exchange and is usually 5% to 10% of the futures contract. These predetermined initial margin amounts are continuously under review: at times of high market volatility, initial margin requirements can be raised.

The main properties identified for options are also valid for futures (derivatives): leverage and hedging. Using futures brings a huge leverage effect as we can have control over a large invested amount of money with a small level of capital (the margin).

Then, price changes of the underlying asset are highly leveraged. If you have bought a given stock, an example of a hedge using futures would be to sell a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.