Most of us have at least once heard about stocks, crypto or bonds, but not so many know about derivatives, another type of security. Derivatives are named for their characteristic of deriving value from underlying assets, such as stocks, commodities etc. The most common types of derivatives are forwards, futures, swaps and options, each with its own set of rules and conditions for the contract to be exercised. The reason that these instruments are not so common is that they are complex, and it’s the same reason why it's impossible to show all their beauty in one article, which is why we will focus on options.
Options are superior to other types of derivatives because they give you a right but not an obligation to exercise them, which is why you pay a fee known as an option premium. With a future contract, for example, you might agree to buy 100 XYZ stocks in 7 days at a price of $50 each, and when those days pass, the stock might cost $49, but due to the futures contract, you are obliged to buy them, making you overpay $100 in total. For instance, if you purchase an option for the same stock quantity and strike price (the strike price of an option is a fixed price at which the owner of the option can buy, or sell, the underlying asset) of $50 for $40, and the stock's price falls to $49 in seven days, you're not obligated to buy at $50. You may choose not to exercise the option, limiting your loss to the $40 premium, as opposed to the $100 you would overpay in a futures contract.
The option can be a call or put. A call one is where a buyer gets the right to buy something in future, while for a put option, the purchaser can sell the underlying security in future. You make a profit from the option by buying it and making more money from a favourable movement in price than what the option premium was, or you can make money by selling it and getting paid an option premium as a reward. Also, the options are divided into American and European. The American ones give you more flexibility because they allow you to exercise them before the date of the agreement. So if we look at an earlier example of using an option, which was actually European, the American one doesn’t make you wait till those 7 days pass, and the price falls; if the stock was worth $52 on day three, you could just exercise your American option at that time. However, those more flexible options come with higher premiums.
Generally, the premium of options is influenced by the current underlying asset prices, the difference between it and the price at which you got the right to buy/sell it, volatility and the duration of an option contract. The relationship between those factors and option premium can be more clearly demonstrated by the Black-Scholes model, which you can see below. This model was developed for the European options but it still can be used to analyse how different variables affect the prices of American options, whose own model would be much more complex due to the time of exercising option being undetermined.
For the sake of simplicity of this article, we will only cover the volatility aspect. The volatility, measured by standard deviation, represents how much and how quickly the value of an asset changes, so the more volatile something is, the more likely its price will jump up, for example, 20% in one day. Therefore, the more volatile the underlying asset is, the higher the possibility of you making a large profit from your option, so the premium will be higher. There are also different types of volatility. The first one is Realised volatility, which is the one actually observed, and the second one is Implied volatility, which is derived from the price of the option, and represents what the market expects volatility to be.
Straddle strategy involves buying or selling (going long or short) a combination of a call and put options with the same underlying asset, agreed price and expiration date. A long straddle can be used if you know that the price of the asset will move significantly, but you don’t know in which direction, which might be before the presidential election, so by purchasing a combination of call and put options, you will profit from any price movement larger than the combination of premiums of both options. Using short straddle is quite the opposite, which we will explore in the next paragraph by looking at how one of the biggest banks monetized them.
In Barclays 2020 report on their US equity derivatives trading strategy, they showed their thorough research, which demonstrated that after different broker platforms removed commissions on certain options, lots of retail investors started mindlessly buying short-term call options on large-cap US tech stocks. This increased demand caused implied volatility to skyrocket, as it is derived from option premiums, which grew. Barclays identified that options on those stocks were overpriced, and hence, they decided to use a short straddle strategy on options with underlying large-cap us stocks, where you sell the same call and put an option, and hence, you yield overpriced premiums. This strategy was proved in the report to beat the market, which is quite inspiring, and proves that, at least in the short term, the EMH doesn’t hold true. The significant downside of using short straddles is that there might be some large losses. This is because you always get a known premium for selling options, but if you were unlucky and the underlying asset price increased 300%, for example, you would significantly lose money.
In summary, options offer unique advantages in the derivatives market due to their flexibility and the control they provide over potential risks and rewards. Understanding the nuances of call and put options, as well as American versus European styles, is crucial for investors looking to navigate this complex landscape effectively. Strategies like the straddle demonstrate the sophisticated ways in which options can be used to capitalize on market movements and volatility. As illustrated by real-world examples such as Barclays' strategy, options trading requires careful analysis and a deep understanding of market dynamics, but it can offer significant opportunities for informed investors.
Source: https://www.scribd.com/document/521690968/Barclays-US-Equity-Derivatives-Strategy-Impact-of-Retail-Options-Trading
Thank you for the simple explanation of the concept of Option.
Question: if you had 100 thousand dollars, what options would you choose in the market today to increase your capital?
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