Derivative securities are available for commodities, equities, bonds, interest rates, exchange rates, and indexes (such as a stock market idex, consumer price index, and weather conditions). A derivative (or derivative security) is an instrument used by people to trade or manage more easily the asset upon which these instruments are based. Investors choose derivatives to either reduce risk by hedging agains losses or take on additional risk by speculating. The investor’s returns are derived solely from changes in the underlying asset’s price behavior. Two of the most common derivative instruments are options and futures contracts.
Options Allow You to Buy or Sell an Asset at a Predetermined Price
An option is a contract to buy or sell an asset at some point in the future at a specified price. The most common type of option is a stock option.* This security gives the holder (purchaser) the right, but not the obligation, to buy or sell a specific number of shares (normally 100) of a certain stock at a specified price (the striking price) before a specified date (the expiration date, typically three, six, or nine months).
Options Are Created by an Option Writer An option writer signs an option contract through a brokerage firm and promises either to buy or to sell a specified asset for a fixed striking price. In return, the option writer receives an option premium (the price of the option itself) for standing ready to buy or sell the asset at the wishes of the option purchaser. Once written and sold, an option may change hands many times before its expiration. The option holder is the person who actually owns the option contract. The original option writer always remains responsible for buying or selling the asset if requested by the holder of the option contract. Two types of option contracts exist: calls and puts. A call option gives the option holder (buyer) the right, but not the obligation, to buy the optioned asset from the option writer at the striking price. A put option gives the option holder (buyer) the right, but not the obligation, to sell the optioned asset to the option writer at the striking price. “How to Make Sense of Option Contracts” explains the relationships between option writers and option holders for both puts and calls.
Most option contracts expire without being exercised by the option holder, and the option writer is the only person to earn a profit. The profit results from the option premium charged when the option was originally sold. Buying and selling options are techniques used by both conservative and aggressive investors.
Conservative Writers Profit by Selling Covered Calls Selling calls can be a fairly safe way to generate income by conservative option writers who own the underlying asset (the stock). When they sell a call, it is described as a covered option because the writer owns the underlying stock. (If the writer does not own the asset, it is a naked option, a speculative position.) When used effectively by conservative option writers, calls can potentially pick up an extra return of perhaps 1 to 2 percent every three months and minimize risk at the same time. In effect, this conservative investor protects himself financially by hedging his investment against loss due to price fluctuation. You can profit by selling a call on stock already owned, giving the buyer the right to purchase your shares at any time during a relatively short period at a fixed strike price. Here is an example. Assume you have 1000 shares of ABC stock originally bought for $56 (total investment of $56,000) and you write a call to sell the shares at a strike price of $60.
The option price is $2, so you gain an instant premium of $2000 (omitting commissions).
Three scenarios are possible:
- If the stock price does not change in three months, the call expires. As the covered call writer, you profit from the $2000 premium.
- If the stock price rises to $65, the holder exercises the call and buys the stock at $60. Your profit is $6000 ($4000 from appreciation in the stock price from $56 to $60, plus the $2000 premium). You missed out on potentially greater profits, however, because you sold the stocks at the striking price of $60. Without the option, you could have sold the stock at $65 per share.
- If the stock price drops to $50, the buyer of the call will not exercise it because the market price is less than the striking price. You keep the $2000 premium, which cuts your loss from $6000 to $4000 ($56 - $50 = $6; $6 X 1000 X $6000).
Conservative Investors Reduce Risks by Purchasing Covered Puts
Buying puts is a way to immunize a conservative investor’s portfolio against severe price declines because they set up a “collar” to safeguard profits. Puts allow the holder of the contract to sell an asset at a specific striking price for a certain time period, commonly three months. For example, if you own 1000 shares of ABC stock originally purchased at $56 per share (total investment of $56,000), you hope that the market price of the stock will go up. If it goes down instead, you may suffer a loss. To reduce this risk, you could buy a put for 1000 shares at a striking price close to the purchase price of the stock for example, $52. The total price of the option contract might be $2000 ($2 per share). Three scenarios are possible:
- If the stock price does not change in three months, the put expires, and you are out only the $2000.
- If the stock price rises to $65, you allow the put to expire because it is greater than the striking price, and again you are out only the $2000. Alternatively, you could sell your shares at $65 and realize a profit of $7000 ($65 X 1000 = $65,000; $65,000 - $56,000 - $2000 = $7000).
- If the stock price drops to $50, you would exercise the put and sell your stock at the striking price of $52, thereby hedging your loss from $6000 ($56 - $50 = $6; $6 X 1000 = $6000) to $4000 ($56 - $52 = $4; $4 X 1000 = $4000).
Speculative Investors Try to Profit with Options
Aggressive investors in the options market attempt to profit in two ways. First, because a market typically exists for each security for a period of three months, the investor can hope for an increase in the value of the option. For example, if the price of a stock is rising, the holder of a call option might sell it to another investor for a higher price than that originally paid. Second, the investor can exercise the option at the striking price, take ownership of the underlying securities, and sell them at a profit.
Investors take a particularly speculative position when they do not own the underlying asset, as when they sell naked calls or sell naked puts. Option traders can suffer considerable losses. For example, the writer of a put may incur a loss when the market price of an optioned asset drops below the striking price. The writer would be forced to buy the asset from the option holder at a price higher than the market price. Writing naked options is high-risk investing.
Speculative Investors Buy Calls to Create Tremendous Leverage
The lure of a call is that the option holder can control a relatively large asset with a small amount of capital for a specified period of time. If the market price of the asset rises to exceed the striking price plus the premium, the holder could make a substantial profit. For example, Jeremy Dietrich, a technology expert from Aurora, Colorado, bought a stock option call on Xerox in March, when the stock was selling for $55 per share. The striking price is $60, the expiration date is the third Friday in March, and the price (premium) of the call is $2 per share. The option contract cost is $200 ($2 X 100 shares under his control). Jeremy hopes that the per-share price for Xerox will rise. He prefers not to buy the stock outright because 100 shares of Xerox would cost him a great deal more $5500 ($55 X 100).
For Jeremy to break even on the call option deal, the price of Xerox shares must rise to $62 before the call expires, as shown in Equation (16.3). If Jeremy exercises the call option, he can buy the stock at $60 from the option writer and sell it on the market for the current market price of $62 (ignoring commissions). In this instance, he earns $2 per share ($62 $60), which offsets the $2 per share purchase price of the option. If the price of Xerox stock rises to $65, Jeremy would make a $3 profit per share, for a total profit of $300. Based on his $200 investment, this gain amounts to a 150 percent return ($300 $200) earned over a short period. If the Xerox stock price fails to reach $60 by late March, Jeremy’s $200 in calls will expire with no value at all, and he will lose the amount he paid (invested) for the options.
Selling Options You would want to sell a put or a call when the option’s market price has risen sufficiently due to changes in the market price of the underlying asset to ensure a profit. Alternatively, you might sell an option to prevent further losses if its market price is dropping.
Aggressive investors in the options market attempt to profit in two ways. First, because a market typically exists for each security for a period of three months, the investor can hope for an increase in the value of the option. For example, if the price of a stock is rising, the holder of a call option might sell it to another investor for a higher price than that originally paid. Second, the investor can exercise the option at the striking price, take ownership of the underlying securities, and sell them at a profit.
Investors take a particularly speculative position when they do not own the underlying asset, as when they sell naked calls or sell naked puts. Option traders can suffer considerable losses. For example, the writer of a put may incur a loss when the market price of an optioned asset drops below the striking price. The writer would be forced to buy the asset from the option holder at a price higher than the market price. Writing naked options is high-risk investing.
Speculative Investors Buy Calls to Create Tremendous Leverage
The lure of a call is that the option holder can control a relatively large asset with a small amount of capital for a specified period of time. If the market price of the asset rises to exceed the striking price plus the premium, the holder could make a substantial profit. For example, Jeremy Dietrich, a technology expert from Aurora, Colorado, bought a stock option call on Xerox in March, when the stock was selling for $55 per share. The striking price is $60, the expiration date is the third Friday in March, and the price (premium) of the call is $2 per share. The option contract cost is $200 ($2 X 100 shares under his control). Jeremy hopes that the per-share price for Xerox will rise. He prefers not to buy the stock outright because 100 shares of Xerox would cost him a great deal more $5500 ($55 X 100).
For Jeremy to break even on the call option deal, the price of Xerox shares must rise to $62 before the call expires, as shown in Equation (16.3). If Jeremy exercises the call option, he can buy the stock at $60 from the option writer and sell it on the market for the current market price of $62 (ignoring commissions). In this instance, he earns $2 per share ($62 $60), which offsets the $2 per share purchase price of the option. If the price of Xerox stock rises to $65, Jeremy would make a $3 profit per share, for a total profit of $300. Based on his $200 investment, this gain amounts to a 150 percent return ($300 $200) earned over a short period. If the Xerox stock price fails to reach $60 by late March, Jeremy’s $200 in calls will expire with no value at all, and he will lose the amount he paid (invested) for the options.
Selling Options You would want to sell a put or a call when the option’s market price has risen sufficiently due to changes in the market price of the underlying asset to ensure a profit. Alternatively, you might sell an option to prevent further losses if its market price is dropping.
.
0 comments:
Post a Comment