Options Explained2

Frontmatter

1. The Basics of Options

Abstract

Obviously, the best way to become familiar with trading options is to trade. As happens in many fields, a book can serve as a useful guide to new concepts and later provide a perspective once experience has been gained — but there can be no substitute for the experience itself. I have written this book therefore as a guide and not as a text book, to assist and accompany the reader as he or she learns, applies and trades the financial products described hereafter. Additionally, the book is meant to help develop an understanding of the mechanics of how option trading works and thereby also help potential market traders anticipate and benefit from the experiences encountered in the actual market.

Robert Tompkins

2. Basic Concepts In Options Pricing

Abstract

In this chapter, I will examine option concepts by using options on IBM stock as our sample underlying asset. Table 2.1 displays the contract specifications for this option contract traded at the Chicago Board Options Exchange (CBOE). This allows one to either buy or sell 100 shares of IBM stock at or before a variety of expiration dates.

Robert Tompkins

3. Advanced Concepts in Options Pricing

Abstract

Now that I have identified the key factors in options pricing (the underlying instrument market price, the strike price, the underlying instrument volatility, the time to expiration, and the risk-free rate) and examined how these factors are synthesised into an option pricing model, I will now discuss how such models are used by most traders in the options markets.

Robert Tompkins

4. Volatility Estimation

Abstract

Of all the noble aims of mankind, surely the incessant search for identifying patterns which govern our world must rank near the top. With the wide range of disciplines which could find the rules we seek, clearly mathematics has been one discipline which has solved more questions than it posed. One could argue that the truest goal of mathematics is to define rules which can lead to predictable behaviour in the future. In this spirit, this chapter will examine the long and colourful history of volatility estimation and show the reader how these principles can be practically applied to the fundamental problem when pricing options, that of an accurate measure of volatility.

Robert Tompkins

5. Advanced Issues in Volatility Estimation

Abstract

While the last chapter examined the standard approaches to volatility estimation, this chapter will cover more advanced issues and cutting edge developments in this area.

Robert Tompkins

6. Directional Trading Strategies

Abstract

In most markets, there are only two possible strategies one can employ to earn profits: one can either buy or sell some underlying asset. To profit, you have to correctly predict which direction the market will take and when. With options, you can likewise profit from correctly predicting market direction, but in addition, you also can gain from changes in the perceptions of risk, and from the passage of time. Furthermore, options allow you to arbitrage price discrepancies easily and completely. Finally, options can be traded between related underlying markets profiting from either relative directional or volatility discrepancies. In this chapter, I will emphasise directional trading strategies that can be used with options on Crude Oil futures, while I will cover volatility strategies, arbitrage and cross market trading strategies for other underlying assets in the following three chapters.

Robert Tompkins

7. Volatility Trading Strategies

Abstract

In this chapter, I will discuss what may be the most creative of the options strategies, volatility trades. As previously explained, volatility is essentially the risk aspect of the market. It is the perception of risk that is “securitised” in the time value component of an option premium. The volatility can be implied in the options price (which includes traders’ expectations of future price movements) or be based upon the actual fluctuations in the price of the asset which underlies the option. As I mentioned in Chapter 4, there are three ways to measure volatility. One method is the historical basis which measures what has happened in the past and is expressed as the annualised standard deviation of percentage changes in the underlying asset. The second method is the implied volatility which is the current volatility associated with the option’s price. Finally, there is the method of volatility estimation which forecasts future volatility by using econometric techniques which incorporate both the historical and implied techniques.

Robert Tompkins

8. Option Arbitrage

Abstract

This section discusses option arbitrage, the last category of option trading strategies where one has a neutral view on the underlying market and on volatility. In most markets, this would preclude any activity, but with options, opportunities may still exist to profit. These opportunities include calendar spreads, “delta neutral” trading, put/call parity arbitrages like conversions, reversals, and box trades and jelly roll spreads.

Robert Tompkins

9. Trading Options Between Markets

Abstract

In this last chapter on options trading strategies, I will examine a set of strategies which to my knowledge has not been thoroughly discussed in any book on the topic. These strategies examine trading options between different underlying markets and are known as Inter-Market trading strategies.

Robert Tompkins

10. Option Hedging Strategies

Abstract

In this chapter, I will examine the applications of options for hedging fixed income securities. Across the world, futures and option contracts on Bonds, Gilts, or Bundesanleihen have proven to be among the most successful of all derivative products. In this chapter I will examine one of the first and certainly the most successful of the Government Fixed income derivative markets: the U.S. Treasury Bond futures and options markets traded at the Chicago Board of Trade (CBOT).

Robert Tompkins

11. Option Portfolio Application

Abstract

This section discusses potential portfolio applications of options. It differs from the previous chapter in emphasis. The last chapter examined options in a tactical light. I examined how one could use call options as substitutes for the purchase of an underlying asset (a US Treasury Bond); how to buy puts to protect against declines; how to sell call options to enhance yields by expecting volatility to decrease; and how to write cash-secured put options in anticipation of a better price in the underlying market. In this chapter, I will place more emphasis on the strategic applications of options in portfolio management. The options contracts I will use to explain these concepts include the Standard & Poors 100 (S&P 100 or OEX) Stock Index option traded at the Chicago Board Options Exchange (CBOE) and options on the Standard & Poors 500 (S&P 500) Stock Index futures traded at the Index and Options Market (IOM) of the Chicago Mercantile Exchange. In addition, I will also examine the use of the S&P 500 Stock Index futures also traded at the IOM. The contract specifications for all these contracts can be seen in Tables 11.1a, 11.1b and 11.1c.

Robert Tompkins

12. OTC Interest Rate Options

Abstract

So far in this book, I have discussed only options that are traded at organised markets. In the 1980s a whole new option market developed to address the unprecedented interest rate, commodity and currency risks that were associated with a variety of economic shocks. These products were not offered at an organised marketplace but were instead offered directly by financial institutions to clients. These products became known as Over the Counter (OTC) options. The principal differences between exchange traded options and OTCs are that exchange-traded options are more actively traded but not very flexible (a restricted range of maturities and strike prices) while OTCs offer tailor-made terms but often with a lower liquidity or at a higher cost. In this chapter, I will examine only interest rate OTCs. In the next chapter, the coverage of OTCs will cover all the major financial markets with the discussion of exotic options.

Robert Tompkins

13. Exotic Options

Abstract

In the financial world, no other product provides as much flexibility as is offered by option contracts.¹ If one reviews the chapters on trading strategies, it will again become apparent that options provide few limitations to traders when devising strategies. It is not surprising that options have become a staple in the capital markets because they provide benefits that no other products can provide. For hedgers, options can allow for guaranteed returns in volatile markets and enhanced yields when prevailing rates of return are low. Indeed, there seems to be almost nothing that cannot be constructed using these innovative products. As further proof of this statement, in the last five years, financial analysts have begun to use the fundamental concepts in options theory to “engineer” entirely new products some of which have never existed before. The fruition of human creativity combined with an extremely flexible product such as the option has led to an entirely new field in financial markets to emerge. This area of contingent claims analysis includes those securities which are known as exotic options.

Robert Tompkins

14. Risk Management of Options

Abstract

In this section, I will address the risk management of options dealing and using a popular computer risk analysis programme, help the reader see how option market makers evaluate and control the risks of their portfolios. In addition, I will show the reader how to use the analytics generated by risk analysis programmes to choose the best options trading strategy.

Robert Tompkins

15. Structure Of Exchange Traded Options Markets

Abstract

In this chapter, I will examine how exchange traded options markets function. Initially, I will explain the role of the Clearing House and the mechanics of margining at a typical futures and options exchange. Then, I will examine in detail the structure of four option markets that have different structures: the Philadelphia Stock Exchange, the European Options Exchange, the Option Market (Stockholm) and the Chicago Mercantile Exchange. At that point, I will finish the chapter with a discussion of a new kind of margining system that is based upon the risk analysis techniques in Chapter 14.

Robert Tompkins

16. Accounting, Regulation And Taxation Issues For Options

Abstract

The last chapter of this book addresses the subjects of operational issues, accounting and taxation around the world¹.

Robert Tompkins

Backmatter