Options And Derivatives

The Wild West of Finance

Derivatives aren t the most trusted of financial instruments. They received some bad press in the mid-1990s when Bankers Trust, the leading marketer of derivatives, was accused by several of its key clients, including Procter & Gamble and Gibson Greetings, of misinforming them about the risk of its derivatives instruments. The trustworthiness of derivatives wasn t helped any when Bankers Trust bankers, which had a reputation for being highflying risk-takers, were caught on tape making dismissive comments about whether their clients would be able to understand what they were doing or had done wrong. Derivatives received another black mark for their role in the bankruptcy of Orange County, California, the largest municipal bankruptcy in U.S. history. In a case similar to the Bankers Trust case, Orange County officials charged that they had been misled about the risk of their investments, which involved complex derivatives. To settle that suit, the county s lead investment banker, Merrill Lynch, agreed to pay $437.1 million.

In 2003, Warren Buffet, one of the most successful investors of all time, spoke out against derivates, stating, [I] view them as time bombs, both for the parties that deal in them and the economic system.

What are these scary things called derivatives? Quite simply, derivatives are financial instruments that derive their value out of or have their value contingent upon the values of other assets like stocks, bonds, commodity prices or market index values.

Derivatives are often used to hedge financial positions. Hedging is a financial strategy designed to reduce risk by balancing a position in the market. Often, hedges work like insurance: a small position pays off large amounts if the price of a certain security reaches a certain price. On other occasions, derivatives are used to hedge positions by locking in prices.

Options

We ll begin our discussion with a look at options, the most common derivative. Options, as the word suggests, give the bearers the option to buy or sell a security without the obligation to do so. Two of the simplest forms of options are call options and put options.

Call options

A call option gives the holder the right to purchase an asset for a specified price on or before a specified expiration date. (Technically, this definition refers to an American option. Standard European call options can only be converted on the expiration date. For simplicity s sake, our examples will assume the call options are American.) The specified price is called the exercise price or strike price. Let s take a look at an example. A July 1 call option on IBM stock has an exercise price of $70. The owner of this option is entitled to purchase IBM stock at $70 at anytime up to and including the expiration date of July 1. If in June, the price of IBM stock jumps up to $80, the holder can exercise the option to buy stock from the option seller for $70. The holder can then turn around and sell it to the market for $80 and make a neat profit of $10 per share (minus the price of the option, which we will discuss later). Or the holder can hold onto the number of shares purchased through the option.

Note: When a call option s exercise price is exactly equal to the current stock price, the option is called an at the money call. When a call option has an exercise price that is less than the current stock price, it is called an in the money call. When a call option s exercise price is greater than the current stock price, it is called an out of the money call.

Put options

The other common form of option is a put option. A put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date. (Again, options in Europe can be exercised only on the expiration date.) For example, a July 1 put option on IBM with an exercise price of $70 entitles its owner to sell IBM stock at $70 at any time before it expires in July, even if market price is lower than $70. So if the price drops to $60, the holder of the put option would buy the stock at $60, sell it for $70 by exercising her option, and make a neat profit of $10 (minus the price of the option). On the other hand, if the price goes over $70, the holder of the put option will not exercise the option and will lose the amount he paid to buy the option.

Writing Options

Sounds pretty neat, eh? But how are these options created? And who buys and sells the stock that the options give holders the right to buy and sell?

Well, there is an entire market called the options market that helps these transactions go through. For every option holder there must be an option seller. This seller is often referred to as the writer of the option. So selling a put option is called writing a put. Anyone who owns the underlying asset, such as an individual or a mutual fund can write options.

Let s go back to our previous example. If you buy the July 1 call option on IBM stock with an exercise price of $70, you are betting that the price of IBM will go above $70 before July 1. You can make this bet only if there is someone who believes that the price of IBM will not go above $70 before July 1. That person is the seller, or writer, of the call option. He or she first gets a non-refundable fee for selling the option, which you pay. If the price goes to $80 in June and you exercise your option, the person who sold the call option has to buy the stock from the market at $80 (assuming he does not already own it) and sell it to you at $70, thus incurring a loss of $10.

But remember that you had to buy the option originally. The seller of the option, who has just incurred a loss of $10, already received the price of the option when you bought the option. On the other hand, say the price had stayed below $70 and closed at $60 on June 30. The seller would have made the amount he sold the option for, but would not make the difference between the $70 strike price and the $60 June 30 closing price. Why not? Because as the buyer of the call option, you have the right to buy at $70 but is not obligated to. If the stock price of IBM stays below $70, you as the option buyer will not exercise the option.

Note: If the writer of the call option already owns IBM stock, he is essentially selling you his upside on his IBM stock, or the right to all gains above $70. Obviously, he doesn t think its very likely that IBM will rise above $70 and he hopes to simply pocket the option price.

Summary options chart
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