Analysis of Plain Vanilla and Combined Option Strategies - Essay Example

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Project Paper Fall Term Analysis of Plain Vanilla and Combined Option Strategies Address: Submitted Table of Contents Table of Contents 1 List of abbreviations 1 List of figures and tables 2 1Introduction 3 1Problem Definition and Objective 3 2Course of the Investigation 3 2Theoretical Framework of Options 5 1Definition and Delimitation of the term “Option” (des Optionsbegriffs) 5 2Characteristics of Options 5 3Main Factors Influencing the Option Price 6 3Conception of the four Plain Vanilla Strategies 8 1Long Call 8 2Short Call 9 3Long Put 9 4Short Put 10 4Introduction to Combined Option Strategies 11 1Covered Call 11 2Protective Put 11 3Straddle 12 4Strangle 12 5Bull spread 13 6Bear spread 14 5Conclusion 15 Reference List 17 Appendix 19 List of abbreviations List of figures and tables 1 Introduction Buyers are option presented with the right, though not an obligation to buy or sell possessive instrument or underlying asset at a market price known as a strike price (Alessio et al, 2001). Such buying or selling may take place on either a set date or a time before the date. The contract that enables such kind of financial trading to take place is referred to as option. There are several option strategies that may be used by the seller. Studies have actually showed that how careful a seller is in selecting an option goes a long way to determine the success of the transaction. This study gives emphasis to two of these option strategies namely plain vanilla and combined options. 1 Problem Definition and Objective The recent development of financial markets is connected with growing uncertainty of market participants. The current conflict in Syria, contrary expectations on the start of the Fed’s reduction of the quantitative easing program as well as mixed signs on economic growth in the US and Europe, are fueling investors fears. In this regard, investors are searching for strategies to manage market movements and minimize exposure to risk. Fortunately, there exist various market instruments that enable risk transfer to other more risk-tolerant market participants. Those instruments are called options and belong to the category of derivatives. Investors are able to trade in derivative instruments offering both – great potential returns and loss. Due to the large investment universe of derivatives, the author is going to reduce the complexity by analyzing the most common option strategies: plain vanilla and combined options. The goal of this project paper is to analyze and demonstrate motives using options in different market conditions to support investors in their investment decisions. Quelle zum ersten Satz 2 Course of the Investigation To introduce the topic of the analysis of option strategies, the theoretical fundamentals of options will be presented in the second chapter. First of all, the definition and delimitation of the term “option” are covered to give the reader a general introduction into the topic. A deeper insight is going to be provided by characteristics and main factors influencing the option price. In this regard, the reader will get the main overview of the theoretical framework. To reduce complexity and give investors a comprehensive overview on common strategies, the author will start with the analysis of plain vanilla options. In the following chapter, the focus will switch to combined option strategies to increase the quantity of investors’ scenarios. In conclusion, all significant observations will be concisely summarized. In this regard, the author is going to break down an illustration with option characteristics 2 Theoretical Framework of Options 1 Definition and Delimitation of the term “Option” (des Optionsbegriffs) An option is generally a contract that gives right to a buyer to complete a buying or selling transaction on a specified date or before the date at a strike price (Frenkel, 2009). The rate at which financial markets are growing have given rise to the use and availability of as many forms and types of options as possible. However, the current study shall be limited in terms of scope of study when dealing with the types of options and other variable aspects of options. Generally, the study shall give emphasis to plain vanilla and combined option. Plain vanilla is a type of option that comes without any special attributes or features but act as derivative investments for the seller (Barabasi and Vicsek, 1991). Plain vanilla is referred to as a derivative because of the system used in determining their values, where values are derived rather than implied from value of the underlying stock (Black and Scholes, 2003). Combined options come to the question when there is a combination of other simultaneous options such as call and put options, which shall be reviewed in the course of the paper. 2 Characteristics of Options Three major characteristics are associated with almost all options. These are noted as expiration date, time of expiration and strike price. As the name implies, the expiration date has been explained by French (1983) as the final date on which the holder of the option is mandated to execute the right to either buy or sell the underlying asset. Time of expiration on the other hand refers to time scope from the moment the purchasing of the option is done to the expiration date described earlier. Strike price has been referred to in many different terms including fixed price and exercise price. However, it generally connotes a fixed price that the underlying asset gets bought or sold for by the holder of the option. Generally, various factors, particularly the type of option being referred to, determine the nature of the characteristics of the option (Bodurtha and Courtadon, 1987). That is, a put or call option may have different expiration time, time of expiration and strike price. One general principle however remains that the strike price is determined right at the start of the transaction. 3 Main Factors Influencing the Option Price Black and Scholes (2003) identifies four major option price components that are affected in almost all forms of options. These four components are intrinsic value, probability of a profit, cost of money, and share price adjustment. For each of these four components, there are different factors that influence them, and by extension the option price. Crowder and Phengpis (2005) makes a list of six main factors that influence the option price components presented above. In the diagram below, each of the six main factors namely underlying price, strike price, time until expiration, volatility, interest rates, and dividends have been assigned to the various components. Fig 2.1 Factors of Option Price Influence From the diagram above, it will be noted that underlying price and strike price influence the intrinsic value. This is because in call option, call prices increase with increasing underlying prices while in put options, put prices decrease with increasing underlying prices (Baillie, 1989). On the part of strike price, they influence probability of profitability because it determines increases and decreases in premium depending on whether or not the strike price is favorable in relation to current underlying price. Time until expiration and expected volatility also influence probability of a profitable move. This is because the expected volatility represents the static range of price moves, regardless of direction; and time of until expiration determines how profitable the option will be, depending on the length of time until expiration. Interest rates and dividends may have minimal influence on option prices but these influences are very significant on cost money and share price adjustment respectively. The figure below presents an example of how the various characteristics of options relate to each other to ensure that there is a balance between them to bring about the expected change. It can be noted that the value of AOL call option fluctuates with the price of the company’s stock changes. Source: Brealey?Meyers (2003) 3 Conception of the four Plain Vanilla Strategies As the use of plain vanilla strategy becomes popular due to various forms of expansions taking place on the financial market, researchers continue to identify various models that can be used to maximize options. In this section, four types of vanilla strategies are analyzed with realistic business examples on how they make profitability for market players. 1 Long Call In its very basic terms, long call involves a market player who undertakes a call option by buying the right to purchase the stock with the hope that the stock prices will go up within a specified timeframe (Frenkel, 2009). The right to purchase the stock is done at a fixed price and is actually not implemented until the expiration date. In a practical example, a trader who buys the right to purchase a stock at 100 units as a premium price may either make a profitable long call or a non-profitable long call depending on the exercise price at expiration. That is if the stock price is 120 units at the expiration, then a profit of 20 units has been made. Where the price of the stock price is 80units at the time of expiration, a lost has been made. In sum, what makes a long call is the fact that there is hope of increase in future stock price and there is also a right to purchase (Barabasi and Vicsek, 1991). In the diagram below, a comparison on effect of stock price changes, strike price, and expiration date on option on prices is undertaken between call option and put option with specified stock price and strike price. Source: Hill (2009). 2 Short Call Short call is certainly the opposite of long call in terms of principle and intent of the trader who engages in the option. This time round the hope of the trader is that stock prices will decrease at a certain time frame instead of going up. To this end, there is a move to sell the call to a buyer, who has the right to make a price quotation (Galai, 1977). The obligation here therefore goes to the seller and the right goes to the buyer to buy at his option. Typical example of this is another trader who decides to sell a stock off at 100 units with the hope that the stock price will go down over a set time. If after the set time, the stock price increases to 120 units, the short losses an amount of 20 units. If on the other hand the exercise price goes down as anticipated to an amount of 80 units, the short call position is said to have made a profit. 3 Long Put There are two major ideas in long put that make them different from other forms of plain vanilla option strategies. These are the right to sell stock and the hope of a future declining stock price (Alessio et al, 2001). To this end, if a marker player predicts that prices of stock will decrease after a specific time frame this player buys the right to sell the stock at a strike price. Technically, undertaking a long put means that the trader is not put under obligation to sell the stock but gains the right to sell as long as the expiration date is not due. In this instance, profit is determined by the stock price at the time of expiration, whereby if the stock price is below the exercise price, a profit is made on the quantum of amount that the exercise price exceeds the premium by (Baillie, 1989). Likewise if the stock price exceeds the exercise price at the set time, there is a lost on the premium. 4 Short Put Short put will be considered the opposite of long put because of variations in principle and market practice. The first form of contrast is that short put takes place when traders hope for increase in stock prices. The second contrast that this has to long put is that the trader buys the stock or sells the put. Significantly, there is an obligation to the seller to make a purchase of the stock from the buyer of the put at an option that is determined by the buyer of the put. The price of the stock at the time of expiration determines whether the short put yields a profit. That is for there to be profit, the stock price must exceed the exercise price at the time of expiration (Galai, 1977). Once the stock price goes below the exercise price, a loss is made on the quantum of premium for which the stock price is less. 4 Introduction to Combined Option Strategies It has been stressed earlier that traders on the financial market have the choice of combining options to ensure that they gain better bargaining power. To be able to do this effectively, there are a number of strategies that can be selected from. Generally, these strategies are selected based on whether a trader is performing a call or a put. 1 Covered Call The combined option strategy of covered call is used as a strategy to enable a trader make a transaction that yields a payoff, same as writing a put option. This means that covered call is ideal with the trader wants to earn a market share that will equate what would have been earned if there was writing of a put option but for some reasons cannot write a put option (Sung, 1995). To achieve a covered call, the one selling the call option must own equivalent amount to the underlying instrument being traded. Commonly, the underlying instrument comes in several forms including securities like shares. Covered call may exist to create a buy-write strategy but this happens after key conditions such as the need for the trader to buy the underlying instrument, when the trader sells the call at the same time (Taylor, 2010). In such a situation when there is sale of the call, a cover is created with the long position found with the underlying instrument because the buyer has the right to demand for the shares to exercise (Bodurtha and Courtadon, 1987). 2 Protective Put A protective put is a strategic hedge that is put in place to ensure that traders are protected against drops in stock prices of the securities they trade in. Such protective hedges can be acquired over the security by buying a put to shield the unlikely event of a drop in stock price (Cox, Ross and Rubinstein, 2009). Essentially therefore, protective put is used in situations where the trader wants to control the value of his capital rather than leaving that to be done by the shocks of the stock market. To this end, the Options Guide (2012) therefore explains that “a protective put strategy is usually employed when the options trader is still bullish on a stock he already owns but wary of uncertainties in the near term.” A concrete example can be used to explain this situation of protective put. If in January an option trader has 200 shares as security in the stock of Coca Cola bottling limited at $40, a protective put may be used as strategy by buying another security from Apple as put option valued at $100. Once this is done, there is assurance on the long stock position against any forms of possible crash (Options Guide, 2012). 3 Straddle Straddle is a peculiar combined option strategy that behaves in much a way that several other strategies do not behave. That is, this strategy has the potential of ensuring that regardless of the direction of price movement on stock market, the trader makes gain. To make this possible, the trader must either buy or sell specific option derivatives that have its determinant of profit on movements with the price of the underlying asset that is bought (Todea, 2011). Traders are often faced with two types of straddle, be it long straddle or short straddle. Generally, when the trader buys both a call option and a put option from a single underlying security, we say a long straddle has been made. On the other hand traders sell a put and a call in a simultaneous manner from one underlying security we say a short straddle has taken place. Short straddle is regarded as non-directional option because they have their profit margins hanging on the premiums of the put and call respectively. 4 Strangle Like a straddle strategy, strangle gives profit making commands to the trader by means of the price that the underlying security commands on the market. There however is a distinction with strangle where profits are often dependent on a minimal exposure level to the direction that the price movement takes (Taylor, 2010). In effect, price movement actually has some commanding power on the profits. But for strangle combined option to be used there must first be either a sale or the buying of specific option derivatives on the market. Generally, traders are exposed to long strangle or short strangle, whereby long strangle purchasing a combined option of call and put from the same underlying security. This time round however, the call option and put option possess different strike prices even though they may expire at the same times. Short strangle on the other hand involves the sale of a combined option of call and put from the same underlying security (Cox, Ross and Rubinstein, 2009). Here also, the put and call options ought to have different strike prices though the expiration times may be the same. 5 Bull spread A bull spread combined option behaves in a somewhat opposite way to a straddle. This is because in a bull spread combined option, the determinant of maximum profit is dependent on price rises that are experienced on the market for underlying securities. As a combined strategy, bull spread may come in individual components as either bull call spread or bull put spread. Generally, when a trader buys a call option that has a lower exercise price and sells another call option with a higher exercise price from the same underlying security, a bull call spread is said to have been constructed (Crowder and Phengpis, 2005). When a bull call spread is undertaken using two call options, it is expected that the two calls will possess the same expiration month just as they will be on the same underlying security. When there is the sale of higher striking in-the-money put options with the aim of purchasing equal number of lower striking in-the-money put options, we say a bull put spread has taken place (Sung, 1995). By principle however, it is expected that the trade will take place on the same underlying security and that it will have the same expiration date. The graph below shows the different behavior of payoffs between call written and bullish spread. From the graph, it will be realized that there is generally a downward decline of the payoff and for that matter profit in cases of call written but in bullish spread, the robustness of the financial behavior leads to a rising payoff and for that matter profits. Source: Bodie, Kane and Marcus (2001) 6 Bear spread Bear spread are generally used in situations where traders on a market have hopes of prices of underlying securities falling. This however remains a combined option because it allows for the buying of call options and put options at a specified strike price but later selling the same combined option having lower strike price on the same underlying security where the purchase was made (Todea, 2011). It must be noted however of the need for the sale on the same underlying security to be made with the same expiration month as when it was bought. An example of this is where Facebook has a share price of $200 and a trader has two call options, one with strike price of $210 for $4 and other with a strike price of $180 for $14. A bear spread can be undertaken by purchasing the $210 call option so that a premium of $4 will be paid so that the call option costing $180 can be sold to earn a premium of $14. 5 Conclusion Based on the various forms of vanilla options and combined strategy options that have been discussed in the paper, a number of conclusions can be made. First, it will be concluded that much of the success level that traders can have on the financial market is largely dependent on how they are able to manipulate the market rhythms to suit their needs. But to be able to properly predict the rhythm of the market to make gains, a trader must understand how various factors affect option prices. This is because the option price has been found to have a lot of contribution in determining the profit margin that a trader who undertakes an option will earn (quote). Among other facts, it is important to pay attention to underlying price, strike price, time until expiration, expected volatility, interest rates, and dividends as all being factors that can easily affect the option price. Again, the paper has made it very clear that there are two major types of vanilla option namely put option and call option. Under each of these also, there could be long and short options. For traders to make the best use of any of these options, they should have the ability of predicting the trend of the stock market to know whether the stock prices are going to go up or down. This is because there are some of these options that work well for declining stock prices and others that work well for increasing stock prices. Finally, it will be concluded that for most optimal results from underlying securities, traders are suggested to with the choice of depending on combined strategies. Reference List Alessio, E., Carbone, A., Castelli, G and Frappietro, V. (2002) Second-order moving average and scaling of stochastic time series, European Physical Journal B, Vol. 27: 197-200 Baillie, R. (1989), Econometric tests of rationality and market efficiency, Econometric Review, Vol. 8: 151-186. Barabasi, A.L. and Vicsek, T. (1991) Multifractality of self-affine fractals, Physical Review A, Vol. 44: 2730-2733. Black, F. and Scholes, M. (2003), The pricing of options and corporate liabilities, Journal of Political Economy, Vol. 81, Issue 3: 637-654 Bodie Z, Kane A and Marcus A. J (2001). Investments. 7th Edition. New York: The McGraw?Hill Companies. Bodurtha, J.N. an Courtadon, G.R. (1987), Tests of an American option pricing model on the foreign currency option market, Journal of Financial and Quantitative Analysis, 153-168 Brealey R. A and Meyers S. C (2003). Principles of Corporate Finance. New York: McGraw?Hill Companies Cox, J., Ross, S. and Rubinstein, M. (2009), Option pricing: a simplified approach, Journal of Financial Economics, No. 7:229-263, Crowder, W. J. and Phengpis, C. (2005), Stability of the S&P 500 futures market efficiency conditions, Applied Financial Economics, Vol. 15, Issue 12: 855-866 French, K. (1983), A comparison of futures and forward prices, Journal of Financial Economics, Vol. 12: 311-342. Frenkel, J. A. (2009), Further evidence on expectations and the demand for money during the german hyperinflation, Journal of Monetary Economics, Vol. 5: 81-96. Galai, D. (1977), Tests of market efficiency and the Chicago Board Options Exchange, Journal of Business, Vol. 50: 167-197 Hill, J. C. (2009). Options, Futures, and other Derivatives. New York: Pearson Prentice Hall Options Guide (2012). Bear Spreads. Accessed September 8, 2013 from http://www.theoptionsguide.com/bear-spreads.aspx Options Guide (2012). Protective Put. Accessed September 8, 2013 from http://www.theoptionsguide.com/protective-put.aspx Sung, H. M. (1995),The early exercise premia of American put options on stocks, Review of Quantitative Finance and Accounting, No. 5: 365—373. Taylor, S.L. (2010), Put-call parity: Evidence from the Australian options market, Australian Journal of Management, No. 15: 203-216 Todea, A. (2011), The influence of foreign portfolio investment on informational efficiency: Empirical evidence from Central and Eastern European stock markets, working paper Appendix Read More