An option is a financial derivative instrument that gives the proprietor the right, but not the obligation, to buy or sell an underlying asset at a pre-determined price within or at a specified time period, in exchange for a premium.
These types of contracts are used by individuals, companies and investors as a means to hedge their exposure in a certain asset or to speculate on the price movement of an underlying security.
Typically, options are divided into two categories, which are vanilla and exotic options, with the main difference being that the latter, are more customizable instruments in terms of payment structures, expiration dates and strike prices, while the former, are more traditional instruments.
Exotic options are usually traded over the counter (OTC), due to their complexity, while vanilla options are commonly traded on organized exchanges.
Given their wide array of strategies and instruments, exotic options will be treated on a separate article.
Option Basics
To fully understand options, we must first highlight some of the key characteristics and common terms that are inherent of these instruments.
- Strike Price: This is the price at which the holder of the option has the right to buy or sell the underlying asset
- Duration: This is the time period in which the holder can exercise its right to buy or sell the underlying asset; there are usually two ways to do this
- American Options: In an American Option, the investor can exercise the option at any time before maturity
- European Options: In European Options, the holder can exercise its right to buy or sell, only at maturity
- Underlying Asset: Options are derivative instruments, which means their existence, and price variation, is dependent on an underlying asset. Although exotic options can offer more complex underlying assets, vanilla options can be done on the following assets, among others (depending on availability)
- Premium: This is the cost of the option, or what the investor pays to acquire the option, or the right to buy or sell an asset at a specified price and date.
There are two factors when it comes to the premium: intrinsic value, which in turn comes with three key concepts that will be explained below, and time value.
1. Intrinsic Value: This is the amount of money investors would get if they exercised the option immediately; it’s essentially the difference between the strike price and the asset’s value when the difference is positive.
- In the money (ITM): This is an expression that is referred to when the option has intrinsic value, which means that the difference in the asset’s price and the strike price is favorable to the holder if he/she were to exercise the option.
- Out of the money (OTM): This is another common term, which is used when the option has no intrinsic value, only extrinsic value, which means the difference of the strike price and the current asset price is unfavorable to the investor if it were to be exercised.
- At the money (ATM): At the money options have no intrinsic value, since it’s a situation where the strike price and the price of the underlying security is exactly the same. Like out of the money options, the holder wouldn’t profit if exercising the option, however, they may end up in the money before it reaches expiration.
2. Time Value: The time factor is extremely important when it comes to the option’s cost or value, since it signifies whatever price an investor is willing to pay above the intrinsic value, in hopes the investment will eventually pay off. In other words, the time left until expiration is a chance for the option to either fall in the money or out of the money. Usually, the more time an option has to expire, the higher value.
In summary these two factors determine the options premium, or cost. From these factors, the next key elements derive and are all considered when pricing an option:
- Volatility
- Type of option
- Underlying Security’s Price
- Time
- Strike Price
- Risk-free rate
Also see: Black-Scholes Formula
Types of Vanilla Options
Having explained some of the basics, the following are the two types of vanilla options, which are fundamental in any complex strategy involving this instrument.
Calls
A call option gives the holder the right, but not the obligation, to buy an underlying security at a specified time and price, in exchange for a premium. The seller of the option is called a writer.
When buying calls, the holder wants the underlying security’s price to go up, so he can exercise his option and buy at a lower price that the market’s.
Example
Let’s suppose your company, based in Mexico, has to acquire USD each month to pay its American supplier.
Given this is an election year, you’re worried the outcome will have a negative effect on the volatility of the Mexican peso, and USD/MXN has a chance to soar. This will have a negative impact on your profit margins, since you sell in pesos back in Mexico.
On January 1st, you buy each dollar at $21 MXN, and you would like to keep it around that, so you decide to buy an option to hedge the volatility of the currency pair. It has the following characteristics:
*The calculation of the premium is not 100% accurate in this example; it is mainly used for didactic purposes
At the time of maturity, the conditions look like this:
January was a pretty volatile month and USD/MXN went way up. This would typically hurt your profit margins; however, since you bought a call option, you have the right to buy the USD/MXN at $21.00.
In this example, the holder benefited from acquiring the option, thus the right to buy was exercised. It could be however, that the price had moved the opposite way, creating a scenario in which the option wouldn’t have to be exercised at all.
Given you used options for hedging purposes, you would still physically buy USD at $22.00 on January 31st, however, your profits generated by the options help compensate the physical loss.
Puts
A put option gives the holder the right, but not the obligation, to sell an underlying security at a specified time and price, in exchange for a premium. The seller of the option is called a writer.
When buying puts, the holder wants the underlying security’s price to go down, so he can exercise his option and sell at a higher price that the market’s.
Example
Let’s suppose your company, sells aluminum on a monthly basis.
Aluminum prices have been very volatile this year, and any downwards movement has a negative impact on your profit margins, since you have to lower the price for your clients as well.
On January 1st, aluminum trades at $1,800/ton and you would like to keep selling at that point, so you decide to buy a put option, in case the price goes down, allowing you to sell at a higher clip. It has the following characteristics:
*The calculation of the premium is not 100% accurate in this example; it is mainly used for didactic purposes
At the time of maturity, the conditions look like this
January was a pretty volatile month and the price of aluminum went way up. In this case, you are benefited from the price movement; however, you bought a put option, which gives you the right to sell at $1,800; given this does not makes sense anymore, you do not exercise this right
The loss is compensated by you physically selling aluminum to your clients at $1,900. Let’s remember, you are using options to hedge, not speculate, although there are many who speculate on stock prices, for example, using options.
For a quick recap of all things we have seen in this article:
Options give the holder the right, but not the obligation, to buy or sell an underlying asset at a pre-determined price within a specified time period, in exchange for a premium
Options can be used for hedging, or for speculative purposes
It’s very important to understand that, when used for hedging purposes, a financial loss would be compensated by a physical gain and viceversa
There are European and American Options, which determine at which point you can exercise the instrument
Elements that go into premium pricing include strike price, volatility and underlying price, and they all derive from intrinsic and time value of the options
A call gives the holder the right to buy, while the put gives the holder a right to sell, both without an obligation to do it
For a more detailed view on how options work and how they can be used for hedging purposes, contact us at www.inhedge.mx, and one of our advisors will be with you shortly.
