Concept note: Options

Let us not start with the definition of options, as legal and financial contracts. Call and put options are derivatives. It derives value from its underlying assets. The prices of options are called premium. The prices of underlying assets while traded fluctuates, up, down, or sideways. These fluctuations are terms as volatility, computed by standard deviation. The market participants, based on their perception, as always expect to buy at lower price and sell at higher prices. In the sport market, one action as could generate profit for an investor[i] is the price difference of buy(long) and sell(short). The reverse is also true. In spot market, under certain condition, participants are allowed to first sell (short) at higher prices and buy (cover) at lower prices. Again, the price difference multiplied by quantity is the net gain. These activities are called short selling.

The options specifications are strike prices, market lot and date of expiry. The strike prices are determined by exchanges, which are round figures at certain intervals, across which prices move, or likely to move. The market lot is a pre-specified quantity at which one bundle of underlying would be traded. The speculator cannot trade at the quantity of their wish. This is to bring in homogeneity and liquidity as participants are allowed to trade in multiple of market lots. The expiry date means the option expires after the date specified and had to be excercised.

There are other class of participants, who intend to gain from such price movements (volatility). They are speculators[ii]. The market for options, with the participation of speculators, determines the price of any option as buyers bid and sellers ask at various prices. Usually, they meet somewhere in the middle and a price is determined. This buying and selling action is soundly grounded on some mathematical considerations.

There are 5 components that determine the value of an option:
1. The price of the underlying stock
2. The strike price of the option
3. The time until the option expires
4. The cost of money (interest rates less dividends, if any)
5. The volatility of the underlying stock

The first four components are easy to figure out. Each can precisely be measured. If they were the only components necessary, option pricing would be trivial to derive. Anyone who could add and subtract could figure it out to the penny.

The fifth component - volatility - is the wild card. It is where all the fun starts. Options on two different underlying could have absolutely identical numbers for all of the first four components and the option for one underlying could cost double what the same option would cost for the other underlying. Volatility is absolutely the most important (and elusive) ingredient of option prices.

Volatility is simply a measure of how much the stock fluctuates. So shouldn't it be easy to figure out? It actually is easy to calculate, if you are content with looking backwards. The amount of fluctuation in the past is called historical volatility. It can be precisely measured, but of course it might be a little different each year.
[i] The term "investor" is intended to include customers or other consumers of financial services.
[ii] The term “speculator” is intended to include customers or other consumers of financial risks.

The Green Shoot Spotter

The breakingviews.com had introduced the Green Shoot Spotter (GSS) in Mar/2009, in an attempt to assess contours of global recovery. GSS classifies economic, corporate and financial news in 5 categories, as outlined.
1 on GSS: Still in real trouble
2 on GSS: Getting less bad
3 on GSS: Not just stabilising but stable
4 on GSS: Slow growth
5 on GSS: Rapid recovery.
The methodology is simple and subjective. A basket of news to be selected in the pool are to be classified and has to be contextual. Once the pool for the week is frozen, the news are classified in 1-5 scale baskets and scored. An example.
GSS on Jun/22/2009 scored 2.35 in 5.
The count of news in baskets 1-5 were: 15 in 1, 4 in 2, 8 in 3, 8 in 4 and 1 in 5.
The total score on these 37 news are 15x1+4x2+8x3+8x4+1x5 = 15+8+24+32+5=84
The index score=84/37=2.35~2.4.
The series of GSS scores could comfortably give a guidance on global recovery process. This is a fantastic way to chaffe news out of noise.