Speculation and Arbitrage with Options, Pricing Options
Arbitrage and speculation are two very different financial strategies, with differing degrees of risk.
Arbitrage involves the simultaneous buying and selling of an asset in order to profit from small differences in price. Often, arbitrageurs buy stock on one market (for example, a financial market in the United States like the New York Stock Exchange) while simultaneously selling the same stock on a different market (such as the London Stock Exchange). In the United States, the stock would be traded in U.S. dollars, while in London, the stock would be traded in pounds.
As each market for the same stock moves, market inefficiencies, pricing mismatches, and even dollar/pound exchange rates can affect the prices temporarily. Arbitrage is not limited to identical instruments; arbitrageurs can also take advantage of predictable relationships between similar financial instruments, such as gold futures and the underlying price of physical gold.
Since arbitrage involves the simultaneous buying and selling of an asset, it is essentially a type of hedge and involves limited risk when executed properly. Arbitrageurs typically enter large positions since they are attempting to profit from very small differences in price.
Speculation, on the other hand, is a type of financial strategy that involves a significant amount of risk. Financial speculation can involve the trading of instruments such as bonds, commodities, currencies, and derivatives. Speculators attempt to profit from rising and falling prices. A trader, for example, may open a long (buy) position in a stock index futures contract with the expectation of profiting from rising prices. If the value of the index rises, the trader may close the trade for a profit. Conversely, if the value of the index falls, the trade might be closed for a loss.
Speculators may also attempt to profit from a falling market by shorting (selling short or simply “selling”) the instrument. If prices drop, the position will be profitable. If prices rise, however, the trade may be closed at a loss.
Option pricing refers to the amount per share at which an option is traded. Options are derivative contracts that give the holder (the “buyer”) the right, but not the obligation, to buy or sell the underlying instrument at an agreed-upon price on or before a specified future date. Although the holder of the option is not obligated to exercise the option, the option writer (the “seller”) has an obligation to buy or sell the underlying instrument if the option is exercised.
Depending on the strategy, options trading can provide a variety of benefits, including the security of limited risk and the advantage of leverage. Another benefit is that options can protect or enhance your portfolio in rising, falling and neutral markets. Regardless of why you trade options – or the strategy you use – it’s important to understand how options are priced. In this tutorial, we’ll take a look at various factors that influence options pricing, as well as several popular options-pricing models that are used to determine the theoretical value of options.
The value of equity options is derived from the value of their underlying securities, and the market price for options will rise or decline based on the related securities’ performance. There are a number of elements to consider with options.
- In-the-money: An in-the-money Call option strike price is below the actual stock price. Example: An investor purchases a Call option at the $95 strike price for WXYZ that is currently trading at $100. The investor’s position is in the money by $5. The Call option gives the investor the right to buy the equity at $95. An in-the-money Put option strike price is above the actual stock price. Example: An investor purchases a Put option at the $110 strike price for WXYZ that is currently trading at $100. This investor position is In-the-money by $10. The Put option gives the investor the right to sell the equity at $110
- At the money: For both Put and Call options, the strike and the actual stock prices are the same.
- Out-of-the-money: An out-of-the-money Call option strike price is above the actual stock price. Example: An investor purchases an out-of-the-money Call option at the strike price of $120 of ABCD that is currently trading at $105. This investor’s position is out-of-the-money by $15. An out-of-the-money Put option strike price is below the actual stock price. Example: An investor purchases an out-of-the-money Put option at the strike price of $90 of ABCD that is currently trading at $105. This investor’s position is out of the money by $15.
The premium is the price a buyer pays the seller for an option. The premium is paid up front at purchase and is not refundable – even if the option is not exercised. Premiums are quoted on a per-share basis. Thus, a premium of $0.21 represents a premium payment of $21.00 per option contract ($0.21 x 100 shares). The amount of the premium is determined by several factors – the underlying stock price in relation to the strike price (intrinsic value), the length of time until the option expires (time value) and how much the price fluctuates (volatility value).
Intrinsic value + Time value + Volatility value = Price of Option
For example: An investor purchases a three-month Call option at a strike price of $80 for a volatile security that is trading at $90.
Intrinsic value = $10
Time value = since the Call is 90 days out, the premium would add moderately for time value.
Volatility value = since the underlying security appears volatile, there would be value added to the premium for volatility.
Top three influencing factors affecting options prices:
- the underlying equity price in relation to the strike price (intrinsic value)
- the length of time until the option expires (time value)
- and how much the price fluctuates (volatility value)
Other factors that influence option prices (premiums) including:
- the quality of the underlying equity
- the dividend rate of the underlying equity
- prevailing market conditions
- supply and demand for options involving the underlying equity
- prevailing interest rates