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Introduction

History of options dates back thousands of years. Social and commercial relations governed by rules similar to option terms came into existence at the dawn of human society. Various records are found in ancient documents and archeological sources dating back to the ages of Pentateuch. In Genesis Jacob purchased an option to marry Laban's daughter Rachel in exchange for 7 years of labor. His prospective father-in-law, however, reneged, perhaps making this the first precedent of option default. Laban required Jacob to marry his older daughter Leah. Jacob obeyed his will, but because he loved Rachel, he purchased another option requiring 7 more years of labor. He exercised the second option on the expiration date and finally married his sweetheart.

Before the early 1970s the options market was poorly organized. Most transactions were executed over the counter, often through the mediation of banks or other financial institutions. Essential terms of trade were not standardized, and in each case they were established through negotiations of the parties concerned. There was no formal and objective pricing mechanism that could be used as the starting point to determine the option premium. The watershed point happened in 1973, when two events brought about a fundamental change in the financial world. This was the year when Fischer Black and Myron Scholes published their famous option pricing model (Black & Scholes, 1973) and the Chicago Board Options Exchange (CBOE) began trading standardized option contracts. The first event provided traders with a formalized algorithm of option pricing. Despite numerous drawbacks, this pricing model had one indisputable advantage: It enabled the comparison of market prices with a benchmark value. The second event initiated the development of an organized options market. This process is still underway today involving a growing number of investors and financial flows in option trading.

At the dawn of the new millennium, an important milestone in the development of the world derivatives market was passed. For the first time the volume of exchange traded options (having less than 30 years of history) exceeded the volume of futures traded since 1848. Since then, options have been continuously dominating among other derivatives.

The undisputed leader in option trading is the U.S. market that absorbs more than two-thirds of the world trading volume. An important peculiarity of the U.S. options market is the competition of many exchanges offering the same product (that is, options for the same underlying asset). Although CBOE surpasses other exchanges with regard to the volume of traded contracts (approximately 30% of the total option trading volume), none of them controls more than one-third of the market. Such a competitive environment contributes to liquidity growth, spread shortening, and commission declining that attracts new market participants.

The prospects of options market development are beyond any doubt. Every year brings in additional financial flows; new trading strategies evolve; and option-based advanced structured products become more and more popular. As time goes by, the influence of large institutional investors will strengthen. In the last several years hedge funds became one of the dominating market drivers, and analysts forecast further inflow of their capital into the option trading. At the same time activity of individual investors on the derivatives markets is expected to become more intense.

The area of options application is extremely wide. Mutual funds, banks, and investment companies use options as an instrument to regulate their investment risks. Buying Put options prevents financial institutions from liquidating long positions when they anticipate the underlying asset plunging. On the other hand, when market growth is forecast, buying Call options limits potential losses (if the forecast fails) to the premium paid for options. Buying options also creates considerable leverage adding to the investment potential and increasing the effectiveness of asset management.

Producers of various goods and consumers of raw materials use options to hedge the risks of market price fluctuations. For example, by purchasing a Put option, an oil producer ensures that its future output will be sold at a price not lower than the option strike price. This is the way the company can be secured against a possible fall in the price of its production. On the other hand, an oil-refining company can buy a Call option for oil, thereby ensuring that its raw material will be purchased at a price not higher than the option strike price. Thus, the oil consumer can be secured against the price growth. International companies can hedge currency risks of their export/import operations by purchasing corresponding currency options.

Use of options to manage risks is called hedging. Another area of applying options, often opposed to hedging, includes a class of speculative strategies aimed at earning profits by creating various structures composed of long and short options.

Speculative option strategies give investors broad opportunities incomparable with possibilities provided by other financial instruments in respect to their flexibility and potential profitability. The main feature of options distinguishing them from the majority of other financial instruments is the nonlinearity of their payoff function (which is the relationship between profit and the future underlying asset price). This feature enables the creation of option combinations possessing almost any desired profit profile that makes options an indispensable instrument in achieving various goals for many financial market participants.

This book is intended for investors who strive to make profits using speculative option trading. The principles described here can be applied to all option strategies. Although some of them are frequently used to demonstrate the techniques of discovering the trading opportunities, whereas other strategies are not even mentioned, this selectivity is merely due to our wish to keep the text within reasonable limits.

The systematic approach presented in this book is based on universal principles that can be applied to options on any type of underlying assets: stocks, futures, currencies, interest rates, and commodities. The same is true regarding different markets: Despite certain national specificities in legislation and regulation terms, options markets of all countries are suited for implementing the systematic approach.

To illustrate the different aspects of the systematic approach and to demonstrate its potential effectiveness in exploring the opportunities of option trading, we use historical data from U.S. exchanges. The research described in this book is based on a database containing 7 years of price history of 2,500 stocks and their options.

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