Personal Finance. Call options
Call options can be used to gain a great deal of leverage over a given financial instrument, whether it be bonds, stocks, commodities, property or currencies, for relatively little outlay. They are used if you feel that prices will rise, without having to actually buy the underlying product. There is risk of total loss if the market moves against you, but this must be considered against the risk of loss of holding the said financial instrument.
One way to look at options that will put it more into focus is to consider them in terms of a property deal. Let's say, for example, your friend has a condo worth exactly 3 million baht. All similar condos are also priced at the same 3 million baht. You think the condo will rise in value, but he doesn't thinks so at all. You are not so interested to tie up 3 million baht in the condo either but you feel it will rise in value nonetheless and that you would like to take advantage of the price rise.
You strike a deal with your friend. He writes a contract, for a price, that gives you the option, but not the obligation, to buy the condo at 3 million baht. He charges you 50,000 baht for the contract, and he puts a time limit of 12 months for you to take up the offer. If after 12 months you haven't contacted him, the contract will become void and you will have lost your 50,000 baht. Let's assume also that a volatile property market ensues soon after you sign the contract.
First prices move downwards, against your expectations. Two months later, the prices drop to 2.8 million baht for similar condos in the market, and your friend also drops his price. You still have the contract which gives you the option to buy the place at 3 million baht but of course you would not exercise your right under the contract if you can pick up his condo or a similar one on the open market for 2.8 million baht.
Your 50,000 baht contract will have much less value because the price will need to move substantially, i.e. back above 3 million baht, for the contract to have any usefulness or value. Yet it has some value because there is still a small chance prices will move up in the future. Remember it has 10 months still left to run. Maybe the original contract is worth now only 5,000 baht instead of 50,000 baht. A bit of a loss, but at least you didn't pay 3 million baht for the condo only to lose 200,000 baht as it dropped to 2.8 million baht.
Your friend also values the contract at 5,000 baht and offers you 5,000 baht to bid you out of the contract. He would, as the writer of the contract make a handsome amount of 45,000 baht for doing nothing and would allay the risk of any further price moves. Not bad for a days work, though note he would have lost 200,000 on the value of the condo!
You are unfazed and decide to hold on to the contract, hoping for a reversal in prices over the course of the next 10 months. Sure enough, slowly but surely your hunch pays off. Eight months later the price has shot up to 3.4 million. Now your contract has real value. You can exercise your right under the contract to buy the condo for just 3 million baht even though the market price is 3.4 million baht. You can then sell the property for 3.4 million and make 400,000 baht in the process. Alternatively your friend could buy you out of the contract for the same 400,000 baht. Not bad for an initial outlay of 50,000 baht. Of course if prices did not recover during the year there would have been a loss of the outlay for the contract namely 50,000 baht.
The above example is an "at-the-money" call option example. It is at the money because the strike price, (the agreed buying price) was at the original market value of the underlying security, (the condo) at the outset. It’s a call option because it is based on a buying transaction on a long position, i.e. a belief prices will move up. As prices moved adversely, the option was worth much less because it became "out-of-the-money".
That means prices needed to move substantially just for the option to have any intrinsic value. But the option still had another element of value, and that was time. In the case above, the ten months was worth something because of the chance of a rebound in prices. If there were only ten days left on the contract it would be almost worthless because the likelihood of a market turnaround in ten days would have been remote. So contracts are priced with these two major elements in mind. Also as part of the pricing model is the volatility in prices. If volatility spikes it means the chance of a large move in a small amount of time will also increase and so the time value part of the option would be worth more.
An in-the-money option is also possible to buy. In the above example the contract could have set a strike price at 3.2 million baht on a current market price of 3 million baht. The contract price, or premium as it is known would be 200,000 intrinsic value plus some time value, but not as much as 50,000 because the price could move down and wipe out the intrinsic value too. You might find this contract worth say 220,000 baht, with 20,000 baht priced as the time value element.
The above is similar to what speculators do in the Thai property market when signing an initial contract with a developer to buy a condo off plan with relatively small outlay. The time limit is essentially the build time, as they will need to resell the contract before the building is erected and the final payment in full is due. The strike price is at the market, ie, the asking price of the unit at the time of the contract being signed.
The volatility element is the expected moves of property prices in the market over the period. The premium paid is the initial contract outlay plus the ongoing monthly payments. In a rising market this is why speculation on off-plan properties is so popular as it allows participants to enjoy property price rises over a one or two year period without having to pay for a condo in full at the outset.
In the movie Rogue Trader which is a true account of a call options trade gone wrong, trader Nick Leeson perpetually bought call options on the Japanese Nikkei 225 index in the hopes of redeeming his position. By doubling up the quantity of options bought every time the market went against him, he dug a big hole in the accounts of Barings Bank which eventually went bankrupt. Thus the risk of total loss must be seen at the outset as an affordable risk to take. Since options have an expiry date they can become completely worthless, whereas holding the underlying security over the long term may allow you turn the position around without a time limit in place, not that there is any guarantee about that either.