Introduction:
Options are one of the three main derivative types (the other two being futures/forwards and swaps) traded on global exchanges. They are effectively contracts that represent the right to buy or sell an asset (stocks, bonds, foreign currencies, etc) at a certain price.
Technical Terms:
Before we go any further, you need to have a vague idea of what the jargon behind options actually means, so I have made a list of the key terms and their definitions below:
Premium: The amount in currency paid for the contract.
Strike Price: The financial value at which the underlying financial asset can be purchased or sold for.
Expiration Date: The date on which the option contract can be either used or becomes worthless.
Intrinsic Value: The payoff received if the option expired at the current price of the underlying asset.
Time Value: Added value given or taken away from the option due to the value of time (more time gives you more options).
In The Money: An option with a positive intrinsic value
At The Money: An option with a strike price close to the current underlying asset level.
Out of the Money: An option with no intrinsic value, but with time value.
American/European/Bermudan Options:
This has nothing to do with where the options are either listed or traded - a common mistake!
European options can only be exercised at the expiry date, while American options can be used any time before the expiry date.
Bermudan options are effectively in-between American and European options and can be exercised on specific dates/in specific periods.
Types of Option:
Put: This gives the holder of the option the right to sell an underlying asset at a certain price.
Call: This gives the holder of the option the right to buy an underlying asset at a certain price.
The easy way to remember what "put" and "call" mean is to think about it in the context of "putting something away" (getting rid of something) and "calling something towards you" (bringing something closer to you).
Binary/Digital: These are very similar to standard put and call options, but in this context you are either right or wrong on the move in the underlying asset (as standard, they never pay off more than $1).
These are best to use if you believe that the option will finish marginally in the money. If you believe that there's going to be a very large move in the underlying asset, then it is better to pick a standard call over a binary call, because the return you can gain grows linearly at prices above the strike price - you'll make more money.
Convertible Bonds: These work in a very similar manner to bonds, in that they can either pay a stream of coupons or be turned into underlying stock in an asset (prior to the expiration date).
Warrants: Warrants usually have longer lifespans than options and tend to act in the style of American options. They also involve the issuing of new stock at the agreed strike price (rather than the purchasing of existing stock).
LEAPS/FLEX: LEAPS (Long-Term Equity Anticipation Securities) are longer dated calls and puts traded on exchanges with standardised expiration dates in January each year. Time to maturity can last up to three years. These have three strike prices at 20% levels in and out of the money relative to the underlying asset.
FLEX (Flexible Exchange-Traded Options) were listed on the Chicago Options Board Exchange (CBOE) in 1993 and are basically LEAPS with a higher level of customisation in regards to the expiry date and the strike price.
OTC Options: These are simply options not traded on a major exchange (e.g. CBOE), sold between private bodies. These will often carry different rules regarding the payment of premium and are open to a very high level of customisation.
Why trade options?
There are a few reasons why people may decide to trade options, but generally the two main reasons are to either use them to hedge an existing portfolio or alternatively as an instrument of speculation.
To understand why someone may trade an option rather than the underlying asset comes down to something called "gearing". Generally, the term "gearing" is used synonymously with "leverage", which isn't wholly true in the case of options markets:
A Crude Gearing Example:
Let us pretend that The Masked Trader Inc. is trading at $100.
The cost of a $102 call option is $20
There are two ways of potentially profiting here:
1. Buy the underlying stock:
Let us say that the stock rises to $200.
In this case you would make a profit of $100 or 100%.
2. Buy the call option:
If I buy the call option for $20, then at expiry (assuming a European option) I can use this, paying $102 for an asset worth $200. I have paid $20 per option and get back $98. This is a profit of $78 per option, but in percentage terms this amounts to:
value of asset at expiry - strike - cost of call *100
cost of call
= 200-102-20 *100
20
=390%
That was a rather crude example, but you can see that in percentage terms it makes more sense to purchase the option than it does to purchase the underlying asset in regards to capital growth.
Showing posts with label derivatives. Show all posts
Showing posts with label derivatives. Show all posts
Wednesday, 22 July 2015
Saturday, 1 November 2014
What Are Swaps?
If you're not awake, swaps have the potential to be a little bit confusing, so pay attention!
Generally speaking, a swap is a form of derivative that's used to help large institutions hedge risk, or reduce costs by the exchanging of cash flows in relation to certain underlying asset groups.
In this example, I'm going to write specifically about interest rate swaps, but swaps can be used for foreign exchange hedging or even speculating on the movements of prices.
How it works:
For this example we have two companies that both want to borrow £1,000,000 and a Swaps Bank:
Company 1 - Wants to borrow at a variable interest rate.
Company 2 - Wants to borrow at a fixed interest rate.
Company 1 goes to its bank, which we'll call Bank 1.
Company 2 goes to its bank, which we'll call Bank 2.
Bank 1 tells Company 1 that if it wants to borrow at a fixed rate it will have to pay 9% and if it wants to borrow at a variable rate it will have to pay the LIBOR (London Inter Bank Offer Rate).
Bank 2 tells Company 2 that if it wants to borrow at a fixed rate it will have to pay 12% and that if it wants to borrow at a variable rate it will have to pay LIBOR +1% (i.e. if LIBOR is 5% they would pay 6%, etc).
Now, the two companies could just accept the rates they're offered, but in the event that they don't want to, a swaps bank can act as an intermediary body, make some money for itself and give the banks the loans they initially wanted:
Despite wanting to pay a variable rate, let's assume that the Swaps Bank tells Company 1 to take the fixed rate of 9% on their £1,000,000 loan.
Despite wanting to pay a fixed rate, let's assume that the Swaps Bank tells Company 2 to take the variable rate of LIBOR +1% on their £1,000,000 loan.
Fixed 9%
------------------------------------->
Company 1 Bank 1
<------------------------------------
£1,000,000
LIBOR +1%
------------------------------------->
Company 2 Bank 2
<------------------------------------
£1,000,000
Halfway Point Summary:
We're about halfway through the transaction and so far both companies have taken their £1,000,000 loans from their respective banks, but at the rates that they didn't want to have.
Here's where the Swaps Banks comes into play, giving them the rates they want and reducing the costs of said rates:
Continuing:
So, the Swaps Bank does a separate deal with each client (it effectively swaps over their interest rates):
The Swaps Bank tells Company 1 that they'll agree a swap on the notional amount of £1,000,000 (it's already got the £1,000,000 in cash from Bank 1), so they'll swap the fixed interest rate to a variable interest rate, but nothing else.
So the Swaps Bank pays Company 1 a fixed rate of 10% on a notional rate of £1,000,000 and receives LIBOR on said £1,000,000.
The Swaps Bank tells company 2 that they'll agree a swap on the notional amount of £1,000,000 (it's already got the £1,000,000 in cash from Bank 2), so they'll swap the variable interest rate to a fixed interest rate, but nothing else.
So the Swaps Bank pays Company 2 LIBOR on a notional rate of £1,000,000 and receives an 10.5% fixed rate on said £1,000,000.
What will happen is that every six months or so, the Swaps Bank will settle the difference for the companies between the rate they're paying the bank and the rate the bank is paying them on £1,000,000.
LIBOR LIBOR
-------------------------------------> -------------------------------------->
Company 1 Swaps Bank Company 2
<------------------------------------ <--------------------------------------
10% 0.5% Profit 10.5%
How The Swaps Bank Makes Money:
The Swaps Bank makes money through taking in more from Company 2 than it's paying out to Company 1:
The Swaps Bank gets 10.5% from Company 2 and Pays 10% to Company 1, thus netting a 0.5% profit.
This may not seem like very much, but in the context of much larger sums of money over many years, these can become highly profitable transactions for the Swaps Bank.
Company Benefits:
In the case of Company 1, they could have paid LIBOR at the bank for a variable rate loan, but with this swap in place they're effectively paying LIBOR -1%, because LIBOR was paid to the Swaps Bank, but they're receiving 10% on £1,000,000 while only paying out 9% to the bank (9%-10%=-1%).
In the case of Company 2, they could have paid 12% at the bank for a variable rate loan, but with this swap in place they're effectively paying 11.5%. This is because LIBOR effectively cancels out between the Swaps Bank and Bank 2 (10.5%+1%=11.5%), making a saving of 0.5% and giving them the fixed rate they wanted.
Risks:
As with pretty much everything in finance there are risks, with the number one risk in this case being that one of the companies will go bust and thus land our Swaps Bank with an unbalanced and unprofitable deal. To hedge against this, most swaps banks will take some form of collateral from the two companies and also carry out a lot of due diligence regarding cash flows, etc.
I hope this clears up any issues with understanding interest rate swaps.
All the best,
The Masked AIM Trader
Generally speaking, a swap is a form of derivative that's used to help large institutions hedge risk, or reduce costs by the exchanging of cash flows in relation to certain underlying asset groups.
In this example, I'm going to write specifically about interest rate swaps, but swaps can be used for foreign exchange hedging or even speculating on the movements of prices.
How it works:
For this example we have two companies that both want to borrow £1,000,000 and a Swaps Bank:
Company 1 - Wants to borrow at a variable interest rate.
Company 2 - Wants to borrow at a fixed interest rate.
Company 1 goes to its bank, which we'll call Bank 1.
Company 2 goes to its bank, which we'll call Bank 2.
Bank 1 tells Company 1 that if it wants to borrow at a fixed rate it will have to pay 9% and if it wants to borrow at a variable rate it will have to pay the LIBOR (London Inter Bank Offer Rate).
Bank 2 tells Company 2 that if it wants to borrow at a fixed rate it will have to pay 12% and that if it wants to borrow at a variable rate it will have to pay LIBOR +1% (i.e. if LIBOR is 5% they would pay 6%, etc).
Now, the two companies could just accept the rates they're offered, but in the event that they don't want to, a swaps bank can act as an intermediary body, make some money for itself and give the banks the loans they initially wanted:
Despite wanting to pay a variable rate, let's assume that the Swaps Bank tells Company 1 to take the fixed rate of 9% on their £1,000,000 loan.
Despite wanting to pay a fixed rate, let's assume that the Swaps Bank tells Company 2 to take the variable rate of LIBOR +1% on their £1,000,000 loan.
Fixed 9%
------------------------------------->
Company 1 Bank 1
<------------------------------------
£1,000,000
LIBOR +1%
------------------------------------->
Company 2 Bank 2
<------------------------------------
£1,000,000
Halfway Point Summary:
We're about halfway through the transaction and so far both companies have taken their £1,000,000 loans from their respective banks, but at the rates that they didn't want to have.
Here's where the Swaps Banks comes into play, giving them the rates they want and reducing the costs of said rates:
Continuing:
So, the Swaps Bank does a separate deal with each client (it effectively swaps over their interest rates):
The Swaps Bank tells Company 1 that they'll agree a swap on the notional amount of £1,000,000 (it's already got the £1,000,000 in cash from Bank 1), so they'll swap the fixed interest rate to a variable interest rate, but nothing else.
So the Swaps Bank pays Company 1 a fixed rate of 10% on a notional rate of £1,000,000 and receives LIBOR on said £1,000,000.
The Swaps Bank tells company 2 that they'll agree a swap on the notional amount of £1,000,000 (it's already got the £1,000,000 in cash from Bank 2), so they'll swap the variable interest rate to a fixed interest rate, but nothing else.
So the Swaps Bank pays Company 2 LIBOR on a notional rate of £1,000,000 and receives an 10.5% fixed rate on said £1,000,000.
What will happen is that every six months or so, the Swaps Bank will settle the difference for the companies between the rate they're paying the bank and the rate the bank is paying them on £1,000,000.
LIBOR LIBOR
-------------------------------------> -------------------------------------->
Company 1 Swaps Bank Company 2
<------------------------------------ <--------------------------------------
10% 0.5% Profit 10.5%
How The Swaps Bank Makes Money:
The Swaps Bank makes money through taking in more from Company 2 than it's paying out to Company 1:
The Swaps Bank gets 10.5% from Company 2 and Pays 10% to Company 1, thus netting a 0.5% profit.
This may not seem like very much, but in the context of much larger sums of money over many years, these can become highly profitable transactions for the Swaps Bank.
Company Benefits:
In the case of Company 1, they could have paid LIBOR at the bank for a variable rate loan, but with this swap in place they're effectively paying LIBOR -1%, because LIBOR was paid to the Swaps Bank, but they're receiving 10% on £1,000,000 while only paying out 9% to the bank (9%-10%=-1%).
In the case of Company 2, they could have paid 12% at the bank for a variable rate loan, but with this swap in place they're effectively paying 11.5%. This is because LIBOR effectively cancels out between the Swaps Bank and Bank 2 (10.5%+1%=11.5%), making a saving of 0.5% and giving them the fixed rate they wanted.
Risks:
As with pretty much everything in finance there are risks, with the number one risk in this case being that one of the companies will go bust and thus land our Swaps Bank with an unbalanced and unprofitable deal. To hedge against this, most swaps banks will take some form of collateral from the two companies and also carry out a lot of due diligence regarding cash flows, etc.
I hope this clears up any issues with understanding interest rate swaps.
All the best,
The Masked AIM Trader
Saturday, 14 June 2014
Using Options To Manipulate The Underlying Equity.
Good morning fellow traders and investors.
Today I'm going to briefly discuss something that I wish I could use in my everyday trading to manipulate equity prices, but sadly I can't, because my account simply isn't large enough.
Most of you will know that options are derivative contracts that allow you to buy (call - you're calling the asset towards you) or sell (put - you're putting the asset away) something at a pre-agreed price.
Now, to quickly make it clear how people practically use these, you can hedge with them or speculate with them. That's pretty much it, although you can use them to assist takeovers, etc.
If I was a hedge fund that wanted an asset to move up in value I would want to create a picture in the derivatives market that looks nice and rosy in order to encourage the buying of that equity. In this instance I would be aggressively buy call options, which would give the impression to the market that the asset was going to rise in value on that day.
This may not sound too fantastic at the moment, but the beauty of options is that you can create an excellent picture for large equities in the derivatives market without spending very large amounts of money: $10,000,000 in on the US equities market is enough. This means that you can (if the market goes with your options play) take profits not only from your proportionately larger position in the underlying equity, but also on the options you purchased as well.
To summarise, the ratio of money to percentage gain you need to move an equity by using derivatives is much better than the ratio you get from just buying the equity at the present market value.
Trade well,
The Masked AIM Trader
Today I'm going to briefly discuss something that I wish I could use in my everyday trading to manipulate equity prices, but sadly I can't, because my account simply isn't large enough.
Most of you will know that options are derivative contracts that allow you to buy (call - you're calling the asset towards you) or sell (put - you're putting the asset away) something at a pre-agreed price.
Now, to quickly make it clear how people practically use these, you can hedge with them or speculate with them. That's pretty much it, although you can use them to assist takeovers, etc.
If I was a hedge fund that wanted an asset to move up in value I would want to create a picture in the derivatives market that looks nice and rosy in order to encourage the buying of that equity. In this instance I would be aggressively buy call options, which would give the impression to the market that the asset was going to rise in value on that day.
This may not sound too fantastic at the moment, but the beauty of options is that you can create an excellent picture for large equities in the derivatives market without spending very large amounts of money: $10,000,000 in on the US equities market is enough. This means that you can (if the market goes with your options play) take profits not only from your proportionately larger position in the underlying equity, but also on the options you purchased as well.
To summarise, the ratio of money to percentage gain you need to move an equity by using derivatives is much better than the ratio you get from just buying the equity at the present market value.
Trade well,
The Masked AIM Trader
Thursday, 12 June 2014
One of my biggest mistakes.
Good morning again,
I'm writing this with one eye on a live graph on my other monitor, so I apologise in advance for any awful spelling, punctuation and or grammar issues.
Probably the worst trade to date that I have ever made was in a company called Armadale Capital. Without going into excessive detail, they invest in other companies within the natural resources sectors, such as Mine Restoration Investments in South Africa along with a few others.
My mistake here was failing to do a full check on the board of directors and also forgetting that the sector is very slow to evolve. It's because of this that I've added to my trading rules the following line: "Do not invest in the natural resources sector - it will take you an age to get your money back".
My failings to profitably trade this company doesn't mean that the company is bad. In fact, it has many aspects that I think are great: the low cost Mpokoto Gold Project in the Democratic Republic of Congo and the low cost fine processing and recycling plant that's a branch of Mine Restoration Investments. I made the mistake of thinking that some quick number crunching from me and a realisation of a distinct difference between the value and price after doing this would make the share price soar.
The share price didn't soar - in fact it fell almost 35% and I closed out that position with a hefty loss (for a nineteen year old).
I think that for me what caused the downwards pressure in the share price was that the Board of Directors had a tendency to release "media updates" that in hindsight were effectively unable to tell shareholders anything new. This combines with their very high salaries gave the impression to shareholders that they weren't pulling their weight properly. I felt like even more of a tit after this trade because I had been given a warning about the board of directors before - albeit on an internet forum.
I learnt a lot from this position:
1. Look for proof of a good consistent board of directors - emailing them first about something arbitrary and seeing if they reply is often a good indicator.
2. Natural resources are a slow evolving area and you'll find it hard to make profits actively trading these companies (although doubtless many people do).
Good luck trading,
The Masked AIM Trader
I'm writing this with one eye on a live graph on my other monitor, so I apologise in advance for any awful spelling, punctuation and or grammar issues.
Probably the worst trade to date that I have ever made was in a company called Armadale Capital. Without going into excessive detail, they invest in other companies within the natural resources sectors, such as Mine Restoration Investments in South Africa along with a few others.
My mistake here was failing to do a full check on the board of directors and also forgetting that the sector is very slow to evolve. It's because of this that I've added to my trading rules the following line: "Do not invest in the natural resources sector - it will take you an age to get your money back".
My failings to profitably trade this company doesn't mean that the company is bad. In fact, it has many aspects that I think are great: the low cost Mpokoto Gold Project in the Democratic Republic of Congo and the low cost fine processing and recycling plant that's a branch of Mine Restoration Investments. I made the mistake of thinking that some quick number crunching from me and a realisation of a distinct difference between the value and price after doing this would make the share price soar.
The share price didn't soar - in fact it fell almost 35% and I closed out that position with a hefty loss (for a nineteen year old).
I think that for me what caused the downwards pressure in the share price was that the Board of Directors had a tendency to release "media updates" that in hindsight were effectively unable to tell shareholders anything new. This combines with their very high salaries gave the impression to shareholders that they weren't pulling their weight properly. I felt like even more of a tit after this trade because I had been given a warning about the board of directors before - albeit on an internet forum.
I learnt a lot from this position:
1. Look for proof of a good consistent board of directors - emailing them first about something arbitrary and seeing if they reply is often a good indicator.
2. Natural resources are a slow evolving area and you'll find it hard to make profits actively trading these companies (although doubtless many people do).
Good luck trading,
The Masked AIM Trader
Wednesday, 11 June 2014
An Introduction
Good morning everyone,
I don't want to bore anyone who actually will end up reading this to death, so I'll keep this reasonably brief and to the point:
I am nineteen year old male who left my grammar school education in the UK after having done some (decidedly mediocre) A-levels and decided to try and make my own way as a trader and investor on the Alternative Investment Market (AIM). I would love to be able to work for an investment management firm or an investment bank in the future - however I'm somewhat doubtful that a guy with no university degree would be considered. Regardless, I plan to move to derivative trading over the the next year or two as I've become more confident with trading raw equities over my (almost) full year of trading.
I had been active in the stock market in my final year of school and having fallen utterly in love with the mechanisms of the market and the excitement it can create, I decided that there was no harm in trying to trade/invest full time while I accumulate my singing exams - fortunately for me I have very supportive parents who were accepting of this.
This is going to be a pretty generic blog with some of my technical analysis, macro ideas and opinions, what I'm buying and and my reasons behind those decisions, etc.
As you can undoubtedly tell, I have no licence to give financial advice and therefore anything I write should be seen as merely a view point and not a symbol to get your wallet out.
Good luck trading!
The Masked AIM Trader
I don't want to bore anyone who actually will end up reading this to death, so I'll keep this reasonably brief and to the point:
I am nineteen year old male who left my grammar school education in the UK after having done some (decidedly mediocre) A-levels and decided to try and make my own way as a trader and investor on the Alternative Investment Market (AIM). I would love to be able to work for an investment management firm or an investment bank in the future - however I'm somewhat doubtful that a guy with no university degree would be considered. Regardless, I plan to move to derivative trading over the the next year or two as I've become more confident with trading raw equities over my (almost) full year of trading.
I had been active in the stock market in my final year of school and having fallen utterly in love with the mechanisms of the market and the excitement it can create, I decided that there was no harm in trying to trade/invest full time while I accumulate my singing exams - fortunately for me I have very supportive parents who were accepting of this.
This is going to be a pretty generic blog with some of my technical analysis, macro ideas and opinions, what I'm buying and and my reasons behind those decisions, etc.
As you can undoubtedly tell, I have no licence to give financial advice and therefore anything I write should be seen as merely a view point and not a symbol to get your wallet out.
Good luck trading!
The Masked AIM Trader
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