Table of Contents

Page No. Table of Contents List of Tables Abstract 02 03 04

1. The trading objectives of hedgers, speculators and arbitrageurs 05 2. How hedgers use options for hedging.06 3. How speculators use options for speculation. 07 4. How arbitragers use options. 08 5. Three (3) factors that may affect pricing of options.. 10 List of References. 11

List of Tables
Page No. Table 1 Speculation strategy used buy speculators in option07 Table 2 Summary of three factors that affect the pricing of options 10

1. The trading objectives of hedgers, speculators and arbitrageurs. Trading objective of Hedgers Hedgers are investors, their objective is to use different markets to minimize or eliminate a particular risk that they face from the potential future movements in the market variables (Hull 2010:47). For example, an airline company will enter into a long position to reduce the risk, related to fluctuation in the price of jet fuel, in contrast a farmer who knows that he/she can harvest in the future enters into a short potion in order to reduce the commodity price falls. Hedgers stand not to make a huge gain but moderately to protect their existing position against the price fluctuations. A perfect hedge is rare but investor can reduce their risk which goes against them.

Trading objective of Speculators Speculators are investors who bet on the future direction of a market variable; either they bet that the price of an asset will go up or down (Hull 2010:13). Their aim in involving in futures trading is to earn profit from the change in price. For example, if a speculator thinks that the British pounds strengthen relative to U.S.doller over the next two months, speculator can purchase British pounds in the sport price and sold it later or can enter into a long position by contrast if its weaken either sell it or go for sort potion.

Trading objective of Arbitrageurs Arbitrageurs are investors who trade in two different markets or exchanges; their aim is locking in a riskless profit by simultaneously entering into transaction in two or more markets (Hull 2010:15). For example, shares of IBM trade on both the New York Stock Exchange and the Boston Stock Exchange; suppose that shares of IBM trade for $110 on the NY market and for $ 105 on the Boston Exchange, a trader could make the following two transactions simultaneously:

y y

Buy one share of IBM on the Boston Exchange for $105 Sell one share of IBM on the New York Exchange for $110

This transaction will generate a riskless profit of $5 for the trader (Kolb and Overdahl 2001: 8-9) but this arbitrage opportunity will not fast for a long in the market (Hull 2010:15). Arbitrageurs help markets to bring price uniformity and price discover.

2. How hedgers use options for hedging. By having the right to sell or buy an asset for a fixed price in a certain date hedgers reduce the upcoming risk in their investment in the market.

y y

Call option right to buy an asset Put option right to sell an asset

Example In April 2011 an investor who owns 1000 Dell shares wants protection against a possible decline in the share price over the next three months. Market quotes are as follows: y y Current Dell share price: $27 Dell July 26.50 put price: $1

The investor could buy 10 put option contracts on Dell on the Chicago Board Options Exchange for a total cost of $1000 with a strike price of $ 26.50; this gives the investor the right to sell 1000 shares for $ 26.50 per share during the next three months (Hull 2010:11). If the market price of Dell falls below $26.50 say for $ 25, the option will be exercised and the investor will realize $26,500 as a whole; How ever investors actual realized amount is $25,500 ($26,500- $1000) (Hull 2010:12). And he/she can buy 1000 Dell shares in the market for $25,000 ($25 x 1000), thus there will be profit of $500($25,500 $25,000) by contrast if the market price is above $26.50, say $28, the options are not exercised and expire worthless because the investor can earn more profit if he/she sells for market price than the option strike price, however the actual profit is after deducting the loss of option premium 1000.

3. How speculators use options for speculation. In speculation the trader has no exposure to offset; they use options to take a position in the market. Either they are betting that the price of the asset will go up or they are betting that it will go down (Hull 2010:13). Example A speculator who in May thinks that Microsoft share is likely to increase in value over the next two months; y y y Current Microsoft share price: $30 per share Microsoft July call option with a 32.50 Strike price is: $1 Speculators investment is: $3000

The two alternative speculation strategies as follows;

Investors Strategy $25 Buy 100 shares Buy 3000 call options

July Share Price $35

-$500 -$3,000

$500 $7,500

Table 1 Comparison of alternative speculation strategy used buy speculators in option The speculators assumption is correct and the price of the stock rises to $35 by July, the first alternative of buying the stock yields a profit of 100x ($35 - $30) = $500; However, the second alternative is far more profitable, call option on the stock with a strike price of $32.50 gives a payoff of $2.50 ($35 - $32.50), the total payoff from the 3000 options under the second alternative is 3000 x $2.50 = $ 7,500; its yields a net profit of $7,500 - $ 3,000 = $4,500; therefore option strategy is nine times more profitable than buying the stock (Hull 2010:14). By Contrast option also gives a grate potential loss. Suppose the stock price falls to $25 by July: The first alternative of buying stock yields a loss of 100 x ($30 - $25) = $500 and because the call options expire without being exercised, the option strategy would lead to a loss of $3000 that the original amount paid for the option (Hull 2010:14).

4. How arbitragers use options. The use of stock options to reap marginal risk free profit by locking value created through price differential between exchanges or violation of Put Call Parity. However the arbitrage opportunity in option hardly exists for individual investors as price inconstancies often appear only for a few moments. If puts are overpriced relative to calls, the arbitrager would sell a naked put and offset it by buying a synthetic put. Similarly, when calls are overpriced in relation to puts, one would sell a naked call and buy a synthetic call. The uses of synthetic positions, common in options arbitrage strategies.There are five arbitrage option strategies;

y y y y y

Box Arbitrage Calendar Arbitrage Conversion Arbitrage Strike Arbitrage Dividend Arbitrage

5. Three (3) factors that may affect pricing of options. There are six factors that affecting the pricing of options, such as current stock price, strike price, the expiration date, volatility of stock price, risk free interest rate and the dividend expected during the life of the option (Hull 2010:244). Out of which the three selected factors are;

Factors

Value of Options European Call European Put American Call American Put

Current Stock Price Strike Price Time to Expiration

Increase Decrease Uncertain

Decrease Increase uncertain

Increase Decrease Increase

Decrease Increase Increase

Table 2 Summary of three factors that affect the pricing of options

Stock Price and Strike Price If the stock price exceeds the strike price (S0>K) in the market at some future time, both European and American call will be exercised. Therefore call options becomes more valuable while the stock price increase and less valuable as the strike price increase. For a put option, it will be exercised if the strike price is more than stock price (K> S0), therefore put options behave in the opposite way of call options. Consequently call options become more valuable as the S 0 increase and less valuable as a K increase, by contrast put options become less valuable as the S0 increase and more valuable as the K increase (Hull 2010:228).

Time to Expiration Generally in American option both value of the call and put option increase the expiration of time. But if the expiration date is long there is more uncertainty in European options, so more possibility for price fluctuation of the underlying asset, this gives more value for party who owns short life option than long life option. For example an investor purchases an option which will expired in three month; it will more expensive for him than purchasing an option which is with ten days of expiration. Because if he buy and keep it for long time there is possibility for huge loss in the premium due to the fact of time depreciation. Therefore an option contracts lose value if the expiration time is long.