THE IMPACT AND BENEFITS FROM THE USE OF OPTIONS

Depending on an attitude, a particular investor chooses his/her own investment strategy. But the most common approach that is used in Kazakhstani market (that is at the same time being introduced by the company, in which the author has been working) is the use of options and its different combinations.

As it is known, option contract provides the buyer of this contract with the right to buy/sell the underlying asset (whether it is stock, bond, currency, or else) at a specific price (which is also called as a “strike price”), at a particular period of time. At the same time, the seller of this option (who is also a “writer”) is obliged to sell/buy that underlying asset. Option has its expiry, toward which the value of the option will decline from the maximum it can be valued. Buyer of the option pays a premium to the writer, which is the maximum loss that he/she can face. At the same time, premium is the only profit that a writer can earn. With the purchase of this right, buyer hereby protects himself from undesired outcomes concerned with the investment.

Option is more attractive instrument than others, like futures, in that it provides an investor with the right, not the obligation to exercise the contract, whereas the forward and futures contract is the obligation. Moreover, option is different from others in that it is not standardized contract, which is an advantage in front of futures, so there is no need in centralized markets and institutions, such as a clearing house in order to sign it. There are actually two most common types of options: American and European. They differ between each other in that American option can be exercised before the expiry, while European is exercised strictly on the expiration date. As a result, American options are more attractive, and are priced more expensively.

The introduction of options into the investment portfolio makes this portfolio more profitable and less risky. With the possible future vision of the trends in the market, one can build different combinations with the options. There are numerous options derivatives, such as straddles, strangles, and collars that allow investors to enter the market, in whatever situation it is.

Straddle is the combination of call and put options that are best used when the market is expected to be highly volatile. No matter where market goes: down or up, it is important that it goes somewhere, not stays in the neutral trend, since both call and put options are applied. When the underlying security is acting as collateral for the purchase of the straddle, it can bring enormous amounts of profit.

Strangle is another combination of options, which is very similar to straddle, except in one thing: it has different exercise prices, while straddle is assigned for only one strike. Both the straddle and strangle are very profitable for the buyer, but, on the other side, it is very risky for the writer.

When the market is highly volatile, or it has the “bearish” trend, it is useful to deal with the third type of the options combination – collar. This derivative limits the downside risk to a portfolio. When an underlying asset is sold at a particular price P, one can purchase a put option at lower price X, and at the same time sell a call option a higher price X+a. The logic of these steps in that if the stock price falls below X, an investor has the right to run the put, which is the protection from big price drops. At the same time, if the price goes up above the call’s strike X+a, then investor has to run this call, thereby fixing his profit. If the stock price stays in this corridor, then no options are being exercised, and the stock is hedged. The profit to an investor in this case is the difference between the call’s premium and the put’s premium. However, usually collar has no significant losses and profits in such cases.

As it is seen, mentioning just these three option derivatives let us make a conclusion that options are the most attractive instruments in the market in the case of right and on-time use. Otherwise it is also one of the riskiest assets. It is important to realize the projections of market trends, since on the basis of these projections the options strategies are chosen.

Every asset has a value. Because of the fact that it exists, it has a value. So do the options. The riskiness problem can be solved when the appropriate valuation of this option is done. The premium is established in accordance with the price of the underlying asset, its volatility, time to maturity, strike price, risk-free rate of return.

There are three most common models for option valuation:

• Black-Scholes Model
• Binomial Options Pricing Model
• Monte Carlo Option Model

All these essentially provide an investor with possible option values that are expected to become real. Initially, Black-Scholes Model was used for valuation of only European options, but with the flow of time, Binomial Options Pricing Model was introduced for American options. Further on, the so-called Monte Carlo Option Model was applied basically for Asian options that were distinct for their multiple sources of uncertainty and complicated features.

CONCLUSION

Investment decisions are very significant to households, since those who invest have a comparative advantage in current income, while those who borrow have a comparative advantage in future one. If so, then there is a possibility to organize capital transactions so that the output attained can be out of production possibilities, which is quite logical in pursuing economic growth.

It was mentioned that markets are efficient, investors are rational and price-takers. But the practice showed that this hypothesis is far from reality. It is important to realize these aspects, because all these market failures cause high risks. In order for an investor to enter the market, it is necessary to determine when to enter it. Then, an investor chooses the industry, and financial instruments. Thereby, he develops his/her own investment strategy.

For a successful investment, it is proposed to use options, since it can work as insurance to certain investment positions. Several types of options and valuation methods are essential in determining what type of insurance to choose and how much adequate money to pay for it. If there is a rational behavior, then theoretically, these options are going to bring significant amount of profit.

Date: 2015-12-17; view: 874