The right (but not the obligation) to buy or sell a certain asset at specific moments in time at a predetermined price
An option is a financial instrument that gives its holder the right to buy or sell an underlying asset at a pre-agreed price at specific moments in time (Hull 2011). The first feature of an option contract is that it gives the holder the right to do something, but not the obligation (Bachelier 1900). If an option entitles to buy an asset, the option is referred to as a call option, while a put option is the right to sell an asset (Brennan and Schwartz 1977). The pre-agreed price at which the holder can buy or sell the asset is the strike price or the exercise price. The time to maturity is the time period which indicates when the holder can exercise the option. When an option is exercised during the entire period, it is commonly referred to as an American option, while a European option contract can be exercised only at the predetermined expiration date (Cassimon et al. 2007). While the holder determines whether he or she is going to execute or exercise the option, the counterparty (the writer of the option contract) needs to deliver the asset to the holder at the pre-agreed price (in case of a call option) or buy the asset from the holder at the pre-agreed price (in case of a put option). The writer’s action is thus dependent on the decision of the holder. For that flexibility, the holder of the option pays an upfront, non-refundable fee to the writer, which is called the premium, reflecting the market price of that option (Cassimon and Engelen 2016; Black and Scholes 1973; Cox et al. 1979; Merton 1973). One can find option contracts on a wide range of assets, including options on common stock (e.g., on a share of Google), options on a stock index (e.g., on the S&P-500, or the Euronext-100 index), options on currencies (e.g., on the EUR/USD exchange rate), options on commodities (e.g., on corn, cattle, soybeans), options on bonds, options on the weather conditions, etc. Options on common stock can also be part of the salary package of senior firm staff. Besides those financial options on a wide range of assets, the concept of options has also been applied in a business context (Cassimon and Engelen 2015; Cassimon et al. 2004).
Options are available on standardized option exchanges or tailor-made from financial institutions in the over-the-counter market. The most important option exchanges include the Chicago Board Options Exchange (CBOE), the CME Group (a merger between the Chicago Mercantile Exchange and the Chicago Board of Trade), the Philadelphia Stock Exchange (now part of NASDAQ), Eurex, NYSE Derivatives (Intercontinental Exchange), the National Stock Exchange of India (NSE), the Bombay Stock Exchange (BSE), and Bovespa. The most traded index options in 2016 included contracts on the Nifty (India), KOSPI 200 (Korea), BankNifty (India), EuroStoxx50 (Eurex), and the S&P500 (CBOE), while most stock options were traded at Bovespa (Brazil), NASDAQ, and NYSE (top three with 47% of the market in 2016). The most actively traded currency option contract in 2016 was on the USD/INR exchange rate.
Example of option price series (in USD)
Call option premia
Put option premia
In the following we show that options can be used both for (speculative) investment transactions and to provide hedging. Options are used as an investment when its holder does not hold the underlying asset and is using the investment in the option to (deliberately) create an open position in which he/she is exposed to risk, i.e., to the price evolutions of the underlying asset, hoping that the price evolves in his/her advantage, leading to a gain; however, prices can also move disfavorably, leading to a realized loss. In this sense, these investments are “speculative.” When, on the contrary, one holds the underlying asset (or will acquire it somewhere in the future, during the lifetime, or at expiration of the option), an option can be used to allow the holder to protect (to hedge) the value of the underlying asset against future adverse price evolutions. In section “Basic Payoff Profiles of Options from an Investment Perspective,” we discuss the basic alternative uses of an option as a speculative investment instrument, showing the different payoff (i.e., the gain/loss) schedules; we also show (in section “Options as a Leveraged Investment”) that such option investments are highly leveraged, i.e., enabling high potential returns (but also high losses) at low investment costs (compared to investment in the underlying asset itself). Section “Using Options for Hedging” then discusses the use of an option from a hedging perspective. In section “Option Combinations and the Put-Call Parity Relationship,” we discuss some more sophisticated option combinations and also point to the theoretical so-called put-call parity relationship. Finally, “Conclusion” section discusses some societal consequences of the introduction and use of options. We will use the example of a stock option and the data of Table 1 throughout the remainder of this contribution.
Basic Payoff Profiles of Options from an Investment Perspective
This section gives an overview of the basic payoff profiles of holding or writing call and put option contracts until expiration date. As such, we assume that the parties do not hold the underlying asset, here the underlying stock, and create a particular position, based on their subjective ideas (or superior information) on the future stock price evolution, hoping to make a profit but at the same time exposing themselves to potential losses in case their subjective ideas or information proves wrong and prices move adversely. We will illustrate the basic payoff profiles using the stock option contract with a strike price of 22.50 USD from Table 1. We provide payoff profiles for the holder of the call option (also referred to as a long call) and the writer of the call option (also referred to as a short call). In a similar vein, we provide payoff profiles for a long put (holder) and a short put (writer).
The holder of a call option has the right to buy one share of the underlying at the strike price of 22.50 USD. Depending on the stock price at expiration, he will exercise his option or let it expire. For instance, when the stock price at expiration is equal to 20 USD, the holder will let the option expire because one needs to pay 22.50 USD upon exercising the option (right to buy at 22.50 USD), while one can buy the underlying stock directly at the market at a price of 20 USD. In contrast, when the stock price at expiration amounts to 25 USD, the holder will exercise the option and buy the underlying stock from the writer of the contract at a price of 22.50 USD, while its market price is equal to 25 USD. In this way, the holder realizes a profit of 25 USD minus 22.50 USD or 2.50 USD, ignoring any premium paid to acquire the call option.
Options as a Leveraged Investment
It is important to understand that options allow for highly leveraged investments. The cost of investing in an option is much lower than that of investing in the underlying asset: investing in say buying a long call (at 22.50 USD) costs the holder 1.15 USD (the premium), while buying the stock itself requires an investment of 22.57 USD. The evolution of the payoff of both will depend on the stock price evolution, but the payoff of an option is much more sensitive to these price changes than that of the investment in the stock: assume that, at expiration, the realized stock price equals 25 USD. Then the rate of return of investment in buying the stock is about 10.8% (the difference between current and buy stock price, which is 2.43 USD, divided by the investment cost of 22.57 USD), while the rate of return on the option equals 117% (the payoff at 25 USD from Fig. 2, which is 2.50 USD, divided by the investment cost of 1.15 USD). Of course, at adverse price changes, the negative rate of return incurred on a stock investment is lower than that on the option, which is often equal, but limited, at losing the full investment cost (when the option expires unexecuted).
Using Options for Hedging
Similarly, when one will acquire the underlying asset somewhere in the future, during the lifetime, or at expiration of the option, an identical strategy of buying a long put can protect against the risk of a drop in the price of that asset in the meantime, leading to the same result as in Fig. 6. If prices turn out lower than the strike price, the holder will exercise the option and sell the share that he/she acquired now at that strike price; as such, a minimal income of 21.50 USD will be secured. At stock prices higher than the strike price, the holder will sell the acquired share in the market at that higher price, and the net income will be that higher price minus the option premium paid.
Option Combinations and the Put-Call Parity Relationship
The explanation of their dual use in this contribution has shown that the creation of the option instrument and option markets has brought about real benefits to its users and financial markets at large, first of all through the ability of individual investors, financial and nonfinancial firms, as well as governments to hedge themselves against all kind of underlying financial risks, which provide more financial stability and insurance against catastrophic outcomes, and, secondly, through the creation of additional financial, highly leveraged investment opportunities, which combine flexibility with low investment input and high potential returns. At the same time, as also shown in this contribution, these benefits come at the expense of potential high costs to the same aforementioned types of users, and even at the world systemic level, due to the potential negative externalities caused when options are used in highly speculative investment strategies that go wrong, in the sense that they result in huge, sometimes unlimited, losses, leading to severe financial distress not only in these entities, but which can then potentially also be transmitted throughout interlinked financial markets, firms, countries, and the financial system at large. Well-known examples include the presence of “rogue traders” such as in the case of Barings Bank or the use of options in speculative currency attacks against countries (see, e.g., Jacque 2015). Preventing such potential catastrophes requires the use of appropriate and rigorous checks and balances at the level of individual firms or governments, self-regulation at the level of financial markets, and other regulatory interventions at the global level (Van Liedekerke and Cassimon 2000).
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