Monday, June 29, 2009

Options uncovered

I was recently reading an article in Fortune magazine about derivative contracts. It hilariously made reference to the 1st derivative contract being contrived around 1994. Well, let me quote directly. "In a 1994 cover story by this writer (Carol Loomis), Fortune called derivatives, then relatively new on the scene, "The Risk That Won't Go Away." Knowing this was not true but not knowing when the first derivative contract "appeared on the scene" I Googled it. Lo and behold Aristotle wrote about them in his seminal work Politics. This recorded work was said to have been writing around 350 years before the common era.

There is the 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 were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort.

Apparently arriving on the scene in Loomis' meaning entails a period of twenty-three hundred and forty-four years. It must be quite the scene for the party to keep going on that long. I digress.

So I wanted to go over derivatives including options, then futures and finally dreaded credit derivative products. Because we must crawl before walk and walk before run, this may take a post or two dozen.

Options come in two basic varieties that can be combined in countless ways to hedge or speculate in the capital markets. The two basic types are call and puts. Now sense these securities are contracts they are very carefully worded. So here it is:
  1. Call option - the right to buy an asset by a certain date for a certain price
  2. Put option - the right to sell an asset by a certain date for a certain price
Easy, right? Well there are a couple more moving parts, which is where everyone gets wound up. There is the strike/exercise price. This is the certain price. Then there is the expiration date or maturity which is the certain date.

Not so bad. Well, here comes the kicker. The option is a right but just like the American voter who has the right to vote does not mean he will show up to vote. Thus, an option purchaser may not exercise the right. All American options, at least the ones on exchanges are for 100 shares. One last thing, there is still the current price or the spot price, which is what the asset is currently worth. Now for an example.

Today is June 29, 2009 The SPY ETF which mimics the S&P500 currently sells for 92.70. The July 2009 contract with a 93.00 strike price sells for $1.62. So if today you wanted to buy the option you would contact a broker, he would find someone to sell a call and then you would pay 162 dollars. This payment gives you the right to purchase the 100 shares of SPY by July 17th.

So two things can happen, either the option is worth money or it isn't come July 17th. If SPY has been bid up to 95 dollars. Then you could use your option right to buy 100 shares of SPY at 93.00 and immediately sell them in the market for 95.00 Gaining 200 dollars. Then you would figure your net takeaway is 38 dollars because it cost you 162 dollars to set up the contract. On the flip side if SPY is at 94.62 or less it would not make sense for you to exercise your option. That is at 94.62 your gain on the sale once you exercised the right would by 162, less the fee to purchase the contract you are at zero. So you do not exercise the option contract.

Now why would someone do this instead of just purchasing the shares outright? There are countless reasons but the most simple explanation is leverage. You only used 162 dollars to purchase an investment that was worth 9,270 dollars in today's market.

The same is true for puts. This time you instead have a hunch that the market is going to fall in the next couple of months. So instead you buy a July put on the SPY ETF with an expiration price of 90.00 for $0.98. So on July 17th the SPY is trading at 85 dollars. You had sent your 98 dollars to the broker on June 29th and now you can sell SPY shares for 90 dollars when the market is trading them at 85. So two things can happen, either you already own a lot (100 shares of SPY) as part of your market portfolio and you just complete the transaction. Or you can buy the shares and add it to your portfolio now at 85 dollars and sell them. Either way you make 500 dollars on the trade and net out the cost of the contract which was 98, so final total is 402 dollars in profit.

Finally, there are two more positions a person could take with these options, which is selling them. An easy example is insurance. I own 1000 shares of Google (GOOG,) but I think the US government may enact anti-trust litigation against them. Thus, I want to insure my portfolio. You look at the case and decide that there is no way the US government will act on such flimsy evidence. You in fact own GOOG stock as well, to enhance your holdings you sell a put to me. That is, I pay you an upfront premium in case the stock falls. If the stock does not fall, or doesn't fall enough, then you picked up free premium plus you still own the stock and its dividend rights. However, the downside risk is steep. If GOOG did start dropping you would end up doubling down at a time when the majority of stockholders are selling.

The other side is the selling of calls. Just like puts, most calls are never exercised. Thus, if you think that MSFT is not going to appreciate in the next month, then you can sell a call, take the premium and sleep peacefully. Of course ...

Here is a quick homework example and I will post the answer up tomorrow.
A July European call sells for $4.70 and the strike price is $95. The stock last traded today at 94. An investor is trying to decide whether to buy 20 call contracts or buy 100 shares, both scenarios cost the same amount. Under which scenarios is the option strategy more profitable, the stock, when are they equivalent?

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