Options are financial derivatives that are tradable via electronic exchanges. They are called derivates because the value they have is derived from the underlying price of for instance a stock or commodity. Options are mostly used for hedging purposes but also offer the possibility to speculate on price movements. In this post a basic explanation of options is provided.
An option gives you the right to buy or sell a specific amount of an underlying product at a predetermined price for a certain period of time. Note that when buying the option you are given a right to exercise the option and not the obligation.
There are two option types; calls and puts. Calls allow you to buy the underlying at the strike price of the option and you can use puts to sell at the strike price. In general, calls are more likely to raise in value when the price of the underlying moves up and puts when it moves down.
How to determine the price of an option?
The variables that are used as inputs to calculate the price of an option are; The value of the underlying, the strike price of the option, the time value of the option, the future expected movement of the underlying (volatility), the interest rate and (for options on stocks) the dividend amount.
So called “Greeks” are used as a measure to explain the changes in the price of the option.
Be aware that the mathematics behind option pricing are quite complex. When used wisely, options can greatly diversify your portfolio. Before you decide to invest in options, be sure to take time and learn how options are priced in more detail.
Who is responsible for providing a market in options?
Market makers, also known as liquidity providers. They provide bids and offers for options on the exchange. Their purpose is to enable other market participants to trade while trying to make the spread between the bid and the ask price.
The job of the market makers is to constantly provide prices. He does this while updating bid and ask prices based on changing market circumstances. As a rule of thumb, options will get more expensive if markets are expected to move. Think about the impact a FED rate decision can have. This can cause markets to either jump up or down. The future impact of such a move is reflected in a higher implied volatility in the options, which makes them more expensive.
How can you make money from providing markets in options?
Every time the market maker trades he is exposed to risk he will try to trade out of. For instance; A market maker provides a 0.95 bid and 1 USD offer in a certain Call. You decide to pay his 1 USD offer in the Call option as you expect the price of the underlying to go up. At this point, the market maker is inclined to improve the price of his bid and raise the price of his offer. His new price might be 0.97 bid and 1.02 USD offered. If someone else comes by and decide to sell the 0.97 bid, the market maker made a 3 cent profit.
Note that prices can also move against the market maker. If the market in the underlying would move up significantly, there is a big change the market maker has to raise his price to a level where buying back leaves him with a loss.
Next to the market makers there are tons of other market participants. Ranging from private day trader, banks, pension funds, portfolio managers, hedge funds and even government institutions. All of these parties have a different incentive to trade options.
Why do people trade options?
The reason to trade these products differs per participant. Day traders aim to make money by speculating on price movements. They might buy a call option because they expect markets to move up. On the other hand, a portfolio manager who is responsible for generating profits for a stock portfolio, might decide to invest a bit of his money to buy put options. These protect him when markets slide down. To make it more tangible, if markets move down, there is a big change his portfolio of stocks will lose money. On the other hand, the puts he just bought are expected to gain in value. This is an example where options are used as a hedge.
A question I get often is; if a portfolio manager is afraid markets go down, why doesn't he just sell his stocks? This is a very good question. The reason for this might be that his portfolio is too large to unwind. The cost of selling shares and later having to buy them back (if circumstances improve) might be higher than just to buy a few puts and hold them for a short period.
Another argument is that if this particular manager starts selling, he can actually put the products he's trading under pressure and start a sell off. This won't happen very easily in liquid products that are watched by many investors, but might occur in less liquid stocks.
This article gives insight in what options are and how market participants use them in practice. Feel free to leave a comment or suggest a new financial market related subject.