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Your Account Basket Checkout. Option basics a quick guide. There are two types of option. The first is a call option. The owner of a call option has the right to buy, but not the obligation to buy. The second is a put option. The owner of a put option has the right to sell, but not the obligation to sell. When we trade options we need to add a little more detail in order to describe exactly what we have done. Let's look at a bond option. Suppose a dealer purchases a call option on a bond.
The option will be related to a specific bond known as the underlying. The call option will give the dealer the right to buy a certain amount of that bond on a future date. This is known as the option expiry date.
On the expiry date the dealer must decide whether to exercise the option. If exercised the dealer buys the bond at a pre-agreed price known as the strike. If the option is not exercised it expires worthless. On expiry if the underlying price exceeds the strike the trader makes money. The higher the underlying price the greater the profit. For every buyer there is a seller. The person who sells the call option is "short". Whereas the call option buyer has the right to buy the underlying bond at the strike price, the call option seller is obligated to sell the underlying abcs option volatility trading strategies pdf download at the strike price.
The higher the underlying price at expiry the greater the potential loss for the call option seller. How could you benefit? You could benefit if the underlying price was beneath the strike price.
You gain as the market price of the bond falls. Whereas the put option buyer has the right to sell the underlying bond at the strike price, the put option seller is obligated to buy the underlying bond at the strike price.
The lower the underlying price at expiry the greater the potential loss for the put option seller. Long option positions create profit opportunities, short option positions create potential losses.
This is abcs option volatility trading strategies pdf download reason why managers and regulators are particularly nervous of short option positions. In theory short positions can lead to unlimited losses and therefore need to be managed abcs option volatility trading strategies pdf download.
Because the buyer of the option pays the seller of the option a premium. This is an up-front payment that compensates the seller for the risks that are being taken. The size of this premium will be proportionate to the risk of abcs option volatility trading strategies pdf download incurred at the time of sale.
Whether you benefit from these trades is entirely dependent on how the market moves. Whilst these strategies can be profitable you may experience losses. There are actively traded option markets for interest rates caps, floors, swaptionsbonds, foreign exchange and commodities. Some of these are exchange traded, many are over-the-counter derivative contracts. Optionality also occurs in products that you would not normally associate with options. Here are two specific examples:. A bank makes a fixed rate mortgage loan.
The normal way to hedge the interest rate risk on this loan is for the bank to pay fixed interest on a swap and receive Libor. The Libor receipt matches the funding cost of the bank. A proportion of mortgages will be pre-paid during their life.
Prepayment often occurs because a mortgage has been refinanced at a lower interest rate. If interest rates decline it becomes economical for borrowers to refinance their original loan and hence pre-payment rates increase.
Pre-payment leaves the bank with an asset that is shrinking whilst the swap hedge remains unchanged. The bank needs to cancel part of the swap. Abcs option volatility trading strategies pdf download because interest rates have fallen, and the bank is paying fixedthe bank will incur a breakage cost.
Passing this cost on the customer is not always straight forward. A bond dealer buys a floating rate note, FRN. The coupon on this particular FRN has a maximum and a minimum interest rate. This FRN contains a cap and a floor, these are options on Libor.
The dealer is short the cap and long the floor. If interest rates increase the FRN coupon may reach its maximum. This represents a real cost for the investor and the value of the FRN will be adversely affected. Valuation of this bond must take into account the value of these options. Dealers who fail to recognise the embedded optionality may be in for an unpleasant surprise. The key point is that you can find option risks in many areas of business and these risks can cause serious problems if they are not managed effectively.
In the money option, ITM: If you exercised Abcs option volatility trading strategies pdf download options you would gain. At the money option, ATM: Out of the money option, OTM: If you exercised OTM options you would lose. Put call parity refers to the fact that different option positions can be combined together to create the underlying.
If you buy an ATM call option on a bond and sell an ATM put option on the same bond you have synthetically abcs option volatility trading strategies pdf download the bond. In other words option prices should be consistent with the price of the underlying.
If not an arbitrage opportunity exists. Traders can use different combinations of calls and puts to create bespoke pay off profiles. These profiles make money in accordance with a trader's expectations. A combination known as a straddle. If the underlying price increased or decreased significantly the trader would make money.
But there are no free lunches! If the underlying price remained relatively static the trader would lose both option premium payments. For vanilla options that are traded in liquid markets eg caps, floors, swaptions and FX options the market price is observable. In this sense "fair value" can be determined be reference to quoted market prices.
However many trades in the over-the-counter market may not be identical in structure to those quoted by banks or brokers. For example the strike or expiry may differ. This makes the pricing and valuation of options problematic particularly for the end user or customer. To price and value options banks use mathematical models, option pricing models. These models have been in existence for 20 - 30 years.
Perhaps the most frequently mentioned model is the Black Scholes model and later variations. The price or option premium compensates them for this risk. In simple terms the premium is the market's estimate of how much money the option seller can expect to lose. Option pricing models provide the monetary value of this risk.
The following is not a rigorous explanation of these models, it is a straight forward explanation of how various inputs used in a model affect the option price.
In order to price an option a dealer inputs information into the pricing model. This information will include whether the option is a call or put, the time to expiry, the underlying price, the strike and the volatility. These inputs will have a direct effect on the value abcs option volatility trading strategies pdf download the option.
You don't have to be an options trader in order to appreciate the effect that these inputs have on price. Here are some simple "rules of thumb". Option traders refer to volatility as a measure of risk. Statisticians refer to annualised standard deviation. This is the dispersion of price around the mean abcs option volatility trading strategies pdf download average, the greater the dispersion the higher the standard deviation or volatility. In simple terms the more things go up and down in price the higher the volatility.
For an option trader this is important. High volatility means that an option has more chance that it will expire in the money and therefore cause the seller to lose money. Now the tricky bit! There are two types of volatility that we could use in order to price options.
The first is historic volatility, the second is implied volatility.