Module 11 - Risk Management - Options PDF

Module 11 - Risk Management Options Part A. Basic Features of Options Contracts Often the investors of long put and calls are retail investors Retail investors do not usually sell the options. The strike price is the predetermined price which the shares of a stock will be exchanged if the options is...

Module 11 - Risk Management Options Part A. Basic Features of Options Contracts Often the investors of long put and calls are retail investors Retail investors do not usually sell the options. The strike price is the predetermined price which the shares of a stock will be exchanged if the options is exercised Put & Call Options Long Put Option: Cap/cease the loss made to increase profits made, option to stop the hedge. This is for those buying the contract. They would want to cease the loss as if they’ve bought at a low price and the price increases, they wouldn’t need to hedge the price decrease. Long Call Option: Don’t use the call option until there is a definite price increase and then it gets put in place to hedge the risk of the price rise. This is for sellers of the contract who would make a profit from the price decreasing as it means at they’ve sold at good price. If the price increases however, they would want to use the option at this time to ensure they don’t make a loss from selling too low. These contracts give you a payout as a safety net when the price turns against the position. Basic Features of Option Contacts An option is a contract that provides its holder with the right (but not the obligation) to exercise the contract. A call option provides its holder with the right to buy the contract item at the exercise price. (X) - Gives holder of that option the right to buy the underlying item like a share at the exercise or strike price. A put option provides its holder with the right to sell the contract item at the exercise price. (X) - Gives holder right to sell the item at the exercise or strike price. We mostly used options where the contract item is a share in a listed company as they trade on the ASX Similar as forward and futures in the sense that it is a contracts Difference is option, as with future and forward has two parties but in the option, one of those two parties has a right but not obligation to exercise the contract. - In a futures contract both opposing parties of the short and long future, have an obligation to buy and sell irrespective of whether spot price goes up or done - In an option, one party has an obligation but the other party has a right. E.g. call option on qantas gives the buyer the right to buy shares at a certain price. In futures and forwards terminology it’s called a futures price not a strike price. The strike price is the price that will take place in the future. E.g. Call option, someone is buying house from owner but they want to buy when they see what property prices are doing in the future - The owner gives the buyer a call option which provides the holder or buy of the option the right to buy the house form owner at a certain price in the future. - Within the next year, the buyer can exercise the option at any time as they have the right to buy the house and the owner has the obligation to sell at that price - Call option price was $1mil but say prices rise to $1.2mil, the buyer will exercise their right to buy at the $1mil. The person that has the right, will pay the amount to the person that gave them the right. This amount is called the option premium. Holder/buyer is paying for the fact that they have the right. AKA option price. Option premium is a sunk cost Rights & Obligations The buyer pays a price (option premium/option price) to the option seller for the option. \ it Has · Her night to buy Has night to sell contract Item at exercise price · Call option buyer has the right to buy the call option at the exercise price ser isnorbosition( · Has obligation to sell untract item at strike Once if call option bexers Thesed call option writer or seller has obligation to sell the call option at the strike price if the call option is exercised. - Put option buyer has the right to sell the put option at the exercise price Has · - obligation to buy ract Her at if put option unt strike price y exerused The put option writer or seller has obligation to buy the call option at the strike price if the put option is exercised. If the buyer of the call option, they pay the premium price to the seller or writer of the option Long position call option holder = has right to buy the item at exercise price - Eg. They have the right to buy Qantas shares at a specific exercise price - The holder of the long position call option would choose to exercise their buy price, if market prices rise and the strike price is lower as they will hedge their risk of prices rising. - Pay the premium long put Long call Short position call option writer = have the obligation to sell the item at their call option price - Eg. They have the obligation to sell the Qantas shares at this strike/exercise price. - If prices rise, the short position holder will lose money as they could have sold at better price. - Receives the premium shortcall short put Long position put option holder = has right to sell the item of the put option at the exercise price - Right to sell Short position put option writer = has the obligation to buy the item at their put option price/strike price. - Obligation to buy. Illustration For the purpose of speculation the example above - One party gets a long call and the provider of the set share price gets the short call - The option holder speculates price will rise and so takes the call option to make a profit from the rise in price. - The writer speculates the price will fall and so exercises the price to make a profit from the price fall. Obligation to sell if holder exercises option. - The long position holder pays a premium to the short call writer In derivative terminology, we talk about expiration not maturity. Strike price is $32.00  Holder starts with a loss of the premium Writer starts with a profit from the premium The premium is paid when the holder buys the call option Example The spot share price (the future price later in contract but current, known as S) The exercise price is X S is the price change in the market. Scenario 1: Share price rises and holder exercises right to buy Scenario 2: Share price falls and holder chooses to opt out In the money out of the money The holder will buy at a discount to the current spot price. Holder pays the option price to exercise their right and are given the share. Holder will take the share and sell it in the market for $32 where she will make a profit as S is than the exercise price. Net profit = (S-X) - premium Writer is at a loss as he loses the contract at a lower value than S value and he misses out on selling the share at market value. out of the money In the money Spot price is less than the exercise price Contract becomes worthless Holder will let the option expire and lose the premium. Writer is unhappy about the drop in share price, but he makes some gain form the premium payment. ASX Option Contracts Traded on automatic trading system, ORDER DRIVEN Access to the market is through brokers who earn a commission on completed trades. The market authorises dealers to make a market for specific options to ensure liquidity The market is used by retail and wholesale traders for speculation and hedging. Process through: Order through brokers who earn a commission and through dealers who make their market for specific options. The Clearinghouse ASX Clear settles transactions and manages default risk - It notates trades: It is the counterparts to both buyer and seller - Requires margin payments or collateral form holders of the short position (as the long holder has no obligation to exercise, it does not pose default risk - The maximum loss the holder can make is the premium paid, writer’s loss is unlimited.) ASX Share Option Contracts Specifications 1) The contract item (or underlying asset) - Actively traded shares chosen form the ASX200, with puts and calls for a range of expiry dates and exercise prices. 2) The contract size e.g. standard is 100 of shares 3) The expiry date e.g. Thursday before the last business Friday in the expiry month 4) The exercise prices (Strike) - Set by the clearinghouse with aim of having range of strike prices distributed around the current share price 5) The option form - ASX offers both European and American forms of equity options When Can the Option Be Exercised? An American option allows holder to exercise at any time prior to expiry A European option can only be exercised on its expiry date. Part B. The Investment & Hedging Capabilities of Calls Holder & Investment & Hedging Capabilities The trader who buys the call option (Long position holder): > - Pays premium to writer Pem - Hopes share price will rise to sell at higher than their purchase to make a net profit less premium writer - Holder if they have exercised and receive the share, can become the writer of another call option contract and sell at a higher premium and strike price. The trader who sells the call option (Short position holder) Prem - Receives the premium S - Hopes value of share fall below exercise price before the option expiry J - Best outcome is the lapse of the option as they keep the share and they get paid the premium. Value of the option contract is dependent on the spot price. Intrinsic Value of Call Options A fundamental contributor to an option’s value is the option’ exercise price (X) and the current share price (S) - The buyer/holder of the call will only consider exercising when S>X - If SX, the maximum value is S-X - If S Intrinsic - for value Pales long position Diagram without the premium The call option’s intrinsic value line rises at 45 degrees capturing dollar for dollar, the increase in the option’s value prices where S>X The curve is asymmetric as when S - Includes line option payoff accounting for premium Asymmetric Intrinsic Value The call option generates intrinsic value when S exceeds X (Known as in-the-money) A decrease in the share price below X (Known as out-of-the-money) but it does not decrease its value below zero. At the money ↓ -in out of the money the money The Exercise Decision Options at expiry will be exercised only when in the money - This applies whatever was paid off from the option as premium is a sunk cost - At expiry, any value captured by the options makes the holder better off, even if it is less than the premium paid for the call as the premium is a sunk cost. - E.g. if $1 premium was paid for a call and it is 30 cents in the money at expiry, exercising reduces the loss for the premium sunk cost from $1 to $70 cents. Calls as Investments An option is a temporary investment in the movement of the price of the contract item. - The investment is the option’s premium - It is a leveraged investment because it can capture favourable share movements at much lower cost than buying the shares. - Leveraged instrument: Exaggerate profit or loss made same as how hedge funds use debt to leverage their returns. Calls can produce very high return when S>X, but they are risky because if SX Lexercising option means cheaper purchase↑ profit potential & includes premium cost & notexercisinyfradations investing g BE Point includes > premium paid Option holders have a short risk exposure at market a se The Seller of a Call The short position in a call has sold the right to the holder and must sell the shares if the call was exercised. - They risk large losses - Premium is most made when exercised - Best outcome is option is left to lapse as they maintain share ownership and gain the premium price. Sellers/writers can close out before expiry (By buying the option), the option price may have increased or decreased by then and so can close out at a profit or a loss. Often find retail investors do not sell the options due to large risk of unlimited loss and limited profit. The seller is not anticipating the share price will exceed the exercise price. If the premium was a fair price, it fairly compensates the short position for the risk of the share price exceeding the exercise price S>X Options - Workshop Part C. Understanding Option Prices An option’s value is determined by: - Intrinsic Value: Spot price - Exercise price 1) Spot Price (S) 2) Exercise price (X) - Time Value: Cost or value of just the time component of the option 3) Time to expiration 4) Expected volatility of spot price (stock price fluctuation) 5) Interest Rate 6) Interest & Dividends  An option’s value can be divided into: 1) Intrinsic Value: It’s value if exercised 2) Time Value: PV of profitability of favourable price movements in the contract item during the option’s remaining time to expiry An option is a wasting security. At expiry, the option is worth its intrinsic value only. Equity options give management extra incentives to work hard for stockholders, to get the share price for the company to increase so that management can also benefit from their own performance. (Company issued options) Exchange traded options: Traded on ASX Determinants of an Options Value 1&2) Spot & Exercise Price - The intrinsic value for a call option is: - Vcall = Maximum of S-X or Zero - Therefore for call options: - if underlying commodity price increases, the value of the call increases (If S>X) - If the exercise price increase, the intrinsic value increases. - For put options: - Intrinsic value increases if the commodity price decreases - Intrinsic value increases when exercise price increases 3) Time to Expiration - Market value of time value is found as: - Market Price - Intrinsic Value = Time Value - Time value increases the longer the term to expiry. Time up, value up - Time value of calls with the same expiry vary between each other, at-the-money value than in/out-of-money. 4) Volatility - Stocks with higher volatility in prices has higher premium as it is more likely for the stock price to rise or fall to the strike price. - E.g. if B’s share price is more volatile than A, B’s option value will increase due to greater likelihood of achieving positive intrinsic value but no greater downside as if the spot price lowers the maximum loss is still zero. The Role of Asymmetry When an option is at the money, it has the most value from volatility as it derives value from price increases but does not lose value when prices fall. Less volatile means it staying at the money point but more volatile means chances of increasing. Time Value & Intrinsic Value Call option is in the money when the stock price is higher than the exercise price Put option is in the money when the exercise price is higher than the stock price. When an option is out of the money, increase in S will not result in intrinsic value until S>X. When an option is in the money, decrease in S can lose intrinsic value. Time value finishes as expiry approaches. Exercise Vs Closeout Holder of in the money option with considerable time to maturity, can exercise the option or close out the position Exercising an option captures it’s intrinsic value only (undertaking/buying the option) Closing out the position would capture both intrinsic and time values and thus achieve the greater profit. (Taking an opposing position) Exercising option means buyer wants the stock. Can close out position meaning the call option is sold on the market at the market price. Example N = 68 5 -. = 62 45. 6 85. Mp TX = 8 95. = 8 95. = $2. 9 - 6. 85 Put Options Gives the buyer of the put option, the right to sell the underlying stock at the strike price, any time on or before the expiry date. Short risk exposure where the long position holder owns the shares and risks the price falling and so decides to take a long exposure by having the right to sell the option at a high price. If they sell at a high price this means that although their shares price will decrease they make an unrealised gain from the sale of the option. Long risk exposure party has the risk exposure of the share price rising and so has the obligation to buy the put option at a price lower than the share price. This will hedge their risk of the price rising and being unable to buy. Buyer of the option has the right to sell the stock at the strike price and pays the premium to the writer Seller of the option has the obligation to buy the stock at the strike price and receives the premium Puts extract value when SX but the premium reduces the net price. Overall, options when used to hedge: - A long call places a ceiling on the amount a person has to pay to acquire an asset - A long put places a floor on the value of an asset. For a call option: - Any option with a strike price above the stock price will be out of the money - Call option traders are seeking lower exchange stock values so that they can later sell at a higher price. For a put option: - Any option with a strike price below the stock price is out the money - Put option traders seek higher strike price as they An option out of the money at expiration is worthless. Call Option Long Position Holder: Right to but an option with a strike price lower than share price as they buy cheaper than what the stock is worth Short Position Holder: Obligation to sell a call option. Benefits from price falling as they would sell at a higher price. Put Option Long Position Holder: Right to sell a put option with a strike price higher than the stock price. Protects them against stock price losses. Short Position Holder: Obligation to buy the put option. Benefits from price rising as this would mean they bought at a low price. 1 Those with. longer maturity have greater time value & Meet price ↓. · 5 $38 49 = X Mp. = $30 $1 = Int 2 30 49-30 =. $0 : TV. 88. 230. -. $0 :. 74 S = 58 49 X = 31 08 IV.. = TV 0 688. = 30 49.31 00 = = $8 0 688 8 -. $0 688. ↳ > same expiry have varying time values value less when Highest out of depent on X volatility money value at the money Mis value when in the money (lim when SX) a) b) Yes exercise Profit = = S-X-Premium 78 98 -. = sX as $7. 42 62 23. - 1 33... =. 00SX) 1- 23 8 49 = MP 2 Those with. 49 (SX)