Options

A Form of Derivative

Serious Information

Trivia

A contract which giving the holder, in return for paying a premium to the option seller, the right to buy or sell a financial instrument or commodity during a period.

Share options allow recipients to buy company stock at preferential prices at some future date, and therefore aim to tie compensation more closely to company performance.

In finance, options are a contract whereby one party (the holder or buyer) has a right but no obligation to exercise a feature of a contract (option) on or before a future date (the exercise date or expiry). The other party (writer or seller) has an obligation to honour a specified feature of the contract. Option trading is used in the futures and share markets and a significant volume of option trading takes place over-the-counter (OTC), ie, not on an exchange. Financial futures options were introduced on the Sydney Futures Exchange in 1982 and were the first such options in the world. Futures options offer buyers a useful method of limiting risk: if an option is not exercised the option taker (buyer) is limited in outlay to the cost of the premium on the option, plus brokerage. Likewise, options over shares offer the right but not an obligation to buy or sell the underlying share. Options over shares were introduced on the Australian Stock Exchange in 1976 and are traded on ASX Derivatives. Options can be either call options, which give the option holder, in return for paying a premium, the right to buy from the grantor of the option at the strike price, or put options giving the option holder, in return for paying a premium, the right to sell to the grantor of the option at the strike price. Since the option gives a buyer a right and a seller an obligation, the buyer has received something of value.

The amount the buyer pays the seller for the option is called an option premium.

Most often the term "option" refers to a type of derivative which gives the holder of the option the right but not the obligation to purchase (a "call option") or sell (a "put option") a specified amount of a security within a specified time span. (Specific features of options on securities differ by the type of the underlying instrument involved.)

Quotes

"In no circumstances enter the derivatives trading market without first agreeing it in writing with me ... at some time in the future it could bring the world's financial system to its knees." Julian Hodge a Banker once said

We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." clamied Warren Buffett The world's greatest stock market investor, known as "the Sage of Omaha", in his Chairman's Letter in the Berkshire Hathaway 2002 Annual Report.

Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

Members of EDX (website edx)London trade futures and options on international exchanges through a common order book, making business easier and more cost effective. We are also committed to creating London’s first over-the-counter (OTC) equity derivatives trade confirmation and clearing service, and listing new equity derivatives contracts where our members demand them. It is their aim to become the most efficient and liquid derivatives exchange in the world.

A real option is a choice that an investor has when investing in the real economy

Traded Options are Exchange traded derivatives, as the name implies.

Vanilla and Exotic Options
Generally speaking a vanilla option a well understood option, whereas an exotic option is complex, or less easily understood. European options and American options on stock and bonds are usually considered "plain vanilla." Asian options, lookback options, barrier options are often considered to be exotic, especially if the underlying instrument is more complex than simple equity or debt.

Models of option pricing were very simple and incomplete until 1973 when Fischer Black and Myron Scholes published the Black Scholes pricing model. Scholes received the 1997 Bank of Sweden Prize in Economic Sciences (Nobel Prize of Economics) for this work, along with Robert Carhart Merton. In a departure from tradition, Fischer Black was specifically mentioned in the award, even though he had died and was therefore not eligible.

One can combine options and other derivatives in a process known as financial engineering to control the risk in a given transaction. The risk taken on can be anywhere from zero to infinite, depending on the combination of derivative features used.

Long Call
A trader who believes that a stock's price will increase may buy the right to purchase the stock (a call option) rather than just buy the stock.

Short Call (Naked short call)
A trader who believes a stock's price will decrease can short sell the stock or instead sell a call.

Long Put
A trader who believes a stock's price will decrease can buy the right to sell a stock at a fixed price

Short Put
A trader who believes a stock's price will increase can sell the right to sell a stock at a fixed price.

Historical Uses of Options
Contracts similar to options are believed to have been used since ancient times. Aristotle wrote about Thales, who bought the option to use olive presses during a harvest. In the real estate market, call options have long been used to assemble large parcels of land from separate owners, e.g. a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the right but no obligation to dramatize a specific book or script. Lines of credit give the potential borrower the right but no obligation to borrow within a specified time period.

Many choices, or embedded options, have traditionally been included in Bond contracts. For example many bonds are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early.

Privileges were options sold over the counter in nineteenth century America, with

Other instruments to manage risk or to assume it include:

Futures contracts
Forward contracts
Swaps

In Bombay an old system was replaced by a daily cash market and introduction of derivatives and options trading

Trading in derivatives can be risky. In Singapore a company moved from its core activities as a jet fuel supplier, to trade in futures and options in the financial derivatives market. This involved betting on the future price of oil, an area the company was not familiar with. This caused massive debts in the company.

companies have been allowed to hand out millions of dollars' worth of stock options without any impact on the most common measure of their profitability. Often in the past this has caused some COs to beef up the share price. Some investors, notably billionaire Warren Buffett, have complained that this gives company bosses every incentive to cook the books, so as to keep the shares pumped up as high as possible. In 2002 Greenspan urged accounting reform.

Railtrack came under controversy in 2001 after it was revealed that six of its directors have been awarded nearly £2m in share options.

In 2003 Microsoft devided to stop rewarding employees with share options.

Share options allow recipients to buy company stock at preferential prices at some future date, and therefore aim to tie compensation more closely to company performance.

During the 1990s, many firms, especially cash-poor but promising hi-tech and internet ventures, granted employees generous blocks of options - often in lieu of pay.

The appetite for these has faded as share prices have fallen, and many investors have become suspicious of the practice, since share option grants are not listed on a firm's balance sheet and are therefore effectively free.

Granting workers shares, rather than share options, is recorded on balance sheets, and therefore gives analysts a clearer view of the company's financial position.
Often a company can use options to motivate in the USA in 2004 under the terms of a deal, about 6,900 pilots would receive share options in return for accepting a 32% pay cut.

Political thriller Syriana was in 2006 at the centre of a new controversy. Stephen Gaghan's script has been mistakenly listed in the Best Original Screenplay category on Oscar's ballot papers. The deadline for nominations is this Saturday, which doesn't leave enough time to correct the mistake. "I wrote a lot of original stuff that wasn't in the book and I'm proud of that," explains Gaghan, "but I optioned a book" So, why didn't Gaghan pick up on the gaff earlier? "Nobody called me, nobody alerted me," he says. Hmm. You'd think, being a writer, he could read the ballot himself.

Trivia

In 2003 abillionaire Swiss family is sued Cantor Fitzgerald, the American broker, and Durlacher (DUC.L), the ailing investment bank, for allegedly reneging on a £35-million contract for difference (CFD) that was supposed to have been placed last month.

A BBC TV documentrary once suggested that these contracts could be used to destroy the western economic system because they allow risky traders to spread the damage of their risky trades to other major companies.

In 1998 Lazio offered 1 million pound just to have first option on a Liverpool striker.

The Jim Henson Company has snapped up the rights in 2006 to Varjak Paw, the novel by SF Said in a deal that also includes an option on the second book in the series The Outlaw Varjak Paw.

Terms for options in foreign nations

Option (Wirtschaft) = Germany

option financière = France

Opzione (finanza) = Italy

Optie = Dutch

Links on websites on subject

http://www.isda.org/ International Swaps and Derivatives Association

http://www.federalreserve.gov/Boarddocs/testimony/2000/20000621.htm Testimony of Chairman Alan Greenspan on Federal Reserve Board's views on the Commodity Futures Modernization Act of 2000

http://www.ise.ie/index.asp The home page of Irish stock exchange

http://www.nasdaq.com/ The homepage of the stock exchange

http://www.cityequities.com/
http://www.moneyweek.com

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