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Options

opcoess

1. What is it?

Options are part of the derivative family, as they are tied up to a main asset. The best way of explaining what is an option is to compare them with car insurances, for instance.

If you buy a car, you will be probably looking for an insurance policy. For such, you must pay a certain amount to an insurance company. If nothing happens to your car, the value you pay to the insurance company is lost. However, if something happens to your car, the insurance company is to pay for all damages. In this example, you are actually buying an option. You spend a small amount (if compared to the total value of the asset) and has a guarantee: if something happens to your car, the insurance company pays for the damage.

As its name suggests, an option of a note or share is nothing more than a choice. You can have the option of buying or selling the asset, if wants to, to an entitled pricing and in a specific period or moment. If you sell an option, though, you will need to sell or buy the asset involved to the option holder, for the stipulated price and timing for that. Back to the car insurance example, when you hire an insurance, you can exercise the option if the car crashes or is robbed. The insurance company, by its turn, must be paying for damages if you want it to do it.

Share options have a lot of characteristics and can be used in a number of situations. It’s possible to make a lot of money with them, but you can also lose it all. Before making any move in this market, you must understand clearly how it works.

Most common uses of options include:

Hedge

The main feature of options is the protection of shares from unpredictable floats in the market. In other words, options are used as tools for managing risks, in order to limit the possibilities of losses for the investors.

Leverage

Increasing the possible return in an investment, but without making huge capital investments. It is possible to multiply gains by investing a relatively low amount. Obviously, that means a higher risk for investors.

Lower transaction costs

Usually, brokerage fees are lower for them, as well as taxes.

Speculation

You can place “bets” for options, at a low cost, with potentially high gains. Speculation is something natural and relatively healthy for options and shares, as it assures liquidity for the market in general.


2. General Characteristics

Standardization

Its negotiation follows standards, that means it is equal to all investors. Standards are stipulated by Bovespa. When you buy or sell a share option, you never know who is the buyer or seller to the original note.

Bovespa-backed risks

When you trade an option, you are not exposed to a nonocompliance from whoever that buys or sells the option to you. That is because Bovespa itself takes over the couterpart risks, in other words, guarantees the operation.

Predetermined maturity

Share options have predetermined expiry dates set by Bovespa. That happens every third Monday of each month.

Expiry dates

Options have expiry dates. That means they have a lifetime, and then just expire. The day of expiration is the last day in an option’s life cycle. From that date on, it is not effective anymore.

Trading “lots”

Options can be just sold or bought in lots of 100 notes, or multiples of it.

Lack of liquidity

Unfortunately, here in Brazil, not all share have options to be traded, and some of them suffer with a lack of liquidity in the market – they have a low trading volume – and because of that, there is no interest in dealing with options for those shares, or the prices for trading them does not pay.

Daily schedule

  • Pre-opening: 9h45am to 10am
  • Trading: 10am to 4h55pm
  • Exercise before expiration: 10am to 4h00pm
  • Closing position before expiration: 10am to 5h00pm*
  • Exercise on expiry date: 10am to 1pm

*Remind that you cannot change your position on options by the expiry date, as they can happen just until the last Friday before the expiration.


3. Terminology

Codes for options are found by using 3 positions:

1. Share name

The first four characters of an option code are found by looking at the company’s stock name. Examples:

PETR = PETROBRÁS

VALE = VALE S/A

OGXP = OGX PETRÓLEO

2. Expiry date

Right after the name, options bring one single letter that names the month of expiration for them:

Maturity Call Put
January A M
February B N
March C O
April D P
May E Q
June F R
July G S
August H T
September I U
October J V
November K W
December L X

For instance, if you have a buying option that brings the letter “A” right after the stock name, such option expires by January (in the third Monday of January, to be specific).

PETR + A

3. Strike Price

Lastly, we have the strike price, or the price that the option can be exercised. Example:

PETR + A + 32 = PETRA32

The code PETRA32 means you are dealing with Petrobras shares, expiring by January, at a strike price of BRL32.00 per share.

There are some terms commonly used in the financial market whose meaning you must know to better understanding how the options market work:

Writers – It’s the person who sold the option, and is forced to deliver the asset in the future, by the determined prices, if the buyer wants to.

Holders – It’s the person who bought the option. He pays a premium to the launcher and then he gets the rights of selling or buying the asset by the expiry date at the nominated price, if advantageous.

Premium – It’s the surcharge paid to the launcher for rights of selling or buying the assets in the future.

Strike – The value of shares fixed for sale or purchase by the expiry date.

Exercise – That’s the last day for exercise the rights of purchase or sale of the asset.

Call – Buying option

Put – Selling option

Long Call – Acquire buying options

Long Put – Acquire selling options

Short Call – Sell a buying option

Short Put– Sell a selling option


4. Types and how they work

There are two different kinds of options, where we can sell and buy:

LONG CALL = Buying a Call (Buying Option)

The first type is a buying option, also known as a Call. When a person buys a Call, he has RIGHTS of buying the asset for a certain price in a future date. Whoever that buys a call is betting the assets will hike. Example:

PETRA32

Asset: 1 Petrobrás stock

Strike: R$ 32

Premium: R$ 0,52

Expiry date: January (A)

First of all, when buying a ‘call’, one must pay the seller a premium. In the example, the seller must be paid BRL0.52 for each option sold. That happens as the seller is unable to sell their shares to anyone else while the option is running. When the expiry date is reached, in January, you can choose whether to buy or not Petrobras shares at the strike price of BRL32.00.

If shares are being traded at BRL40.00 by the expiration date, buying at BRL32.00 would be obviously advantageous, as you can literally buy at 32.00 to sell it at 40.00 in the next moment.

However, if shares are being traded at BRL20.00, you should probably choose not to buy them at BRL32.00, as it is much cheaper in the cash market. Hence, we have the following graph:

gráfico Long call_cleanCaption:

Red = Loss

Yellow = Loss because of the premium

Green = Profit

That leads to:

If shares reach BRL32.00 by the expiry date, then we just lose the premium paid to the seller, or BRL 0.52 (red level in the graph).

If shares, however, are reaching anything between BRL32.01 and BRL32.52, we should have a small loss (yellow line). For example, if at maturity date the Petrobras stocks are being traded at R$ 32,50, than you will buy the stock at R$ 32,00, and sell it to the Market at R$ 32,50, having a loss bt R$ 0,02, because you had to pay the premium.

For any trading value above BRL32.52 by the expiry date, the results will be a profit (green line).

*Brokerage fees were disconsidered.

SHORT CALL = Selling a Call (Buying Option)

When we sell a Call, we are forced to sell a share by an expiration date, if the buyer wants to. For such, we are paid a premium, and can no longer sell the shares involved to anyone else. We must hold them through the expiry date. Whoever that sells a call expect shares to not change a lot. Example:

PETRA32

Asset: 1 Petrobrás stock

Strike: R$ 32

Premium: R$ 0,52

Expiry date: January (A)

When selling an option of PETRA32, we earn BRL0.52 for each traded share. We can’t sell the Petrobras shares until the expiry date, so we have the following graph:

gráfico Short call_clean

Caption:

Red = Loss

Yellow = Loss because of the premium

Green = Profit

If shares are traded by less than BRL32.00 by the expiry date, than the titular of the options may not be exercising his rights of buying. So received premiums remain with you and the option expires. You keep Petrobras shares and made a profits of BRL0.52 per share. Remind that your profits will always be BRL0.52 per share tops per option sold.

If shares reach anything between BRL32.01 and BRL32.52 by the expiry date, the titular should execute the options and you’ll be forced to sell him the shares. In this case, you profits will be lower as shares prices up (yellow line). If shares are being traded at BRL32.50, you must sell them to the options’ owner by BRL32.00, which means your profits reach only BRL0.02 per share.

If by expiry date Petrobras shares are being traded at more than BRL32.52, losses may be unlimited (red line). It’s actually more a matter of opportunity costs. If the titular of an option you sold bought Petrobras options valued at BRL32.00, and share prices reach BRL50.00 by the expiry date, you “could” earn those BRL18.00 more per share, but will be forced to sell them for BRL32.00. Of course you could have earned some bucks yet, if you had sell those shares for R$ 50,00, instead R$ 32,00.

LONG PUT = Buying a Put (Selling Option)

When we buy a “Put”, we get rights of selling a particular share by an expiration date. For such, we must pay a premium for the Put seller. Whoever that buys a ‘Put’ expect the respective shares to drop. Example:

PETRM32

Asset: 1 Petrobrás stock

Strike: R$ 32

Premium: R$ 0,52

Expiry date: January (M)

When buying a PETRM32 option, we pay BRL0.52 for each Put. That pays him for keeping the shares until the expiry date, when we can opt for buying them or not, in January, for the strike price, or BRL32.00 in this particular case. So we have the following graph:

gráfico Long Put_clean

Caption:

Red = Loss

Yellow = Loss because of the premium

Green = Profit

If shares are being traded below BRL31.48 by the expiry dates, you should exercise the options (green line). That means you will sell shares for BRL32.00, and then you can buy them back for less than you actually paid. So, you made profits. For instance, let’s say Petrobras shares are reaching BRL30.00 by the expiration date. You exercise rights of selling them, no worries. So you can short sell them for BRL32.00, buying back for BRL30.00, making profits of BRL1.48 per share (premium values deducted).

If shares are between BRL32.00 and BRL31.48 by the expiry date, you should equally sell them. In this case, your profits drop as prices rise (yellow line).

For instance, if Petrobras shares are being traded by BRL31.48 by the expiration date and you exercise rights of sellin at BRL32.00, you are making losses of BRL0.02 per share.

If by the expiration date Petrobras shares are being traded above BRL31.48, then you just lose the premium paid to the seller, or BRL0.52 (red line).

SHORT PUT = Selling a Put (Selling Option)

When we sell a Put, we are forced to buy a particular share by an expiry date, for a named strike. For such, we receive a premium at the moment we sell the option. Whoever that sells a Put expects the assets to change slightly. Example:

PETRM32

Asset: 1 Petrobrás stock

Strike: R$ 32

Premium: R$ 0,52

Expiry date: January (M)

When we sell a Put PETRM32, we receive BRL0.52 for each sold option. By the expiration date, we are forced to buy a Petrobras share if the buyer wants to. So we have the following graph:

gráfico Short Put_clean

Caption:

Red = Loss

Yellow = Loss because of the premium

Green = Profit

If by the expiration date the shares are traded by BRL31.48 (red line), the option’s owner will be probably exercising the option, selling the shares for BRL32.00. In other words, he sells for BRL32.00 something that is worth less. You received BRL0.52 per option, but was forced to purchase shares for BRL32.00, accounting a loss.

If shares are reaching anything between BRL32.00 and BRL31.48, you should be exercised by the option’s owner, and forced to buy shares at BRL32.00. In this case, your profits drop as shares pricing fall (yellow line). For example, if shares a reaching BRL31.50 by the expiration date, and you are forced to buy them for BRL32.00, you will still be making a profit of BRL0.02 per share.

However, if shares are being trade for more than BRL32.00, options should expire with no action, as the owner should not be willing to exercise them. Your profits then will be the entire premium value.


5. Classification

Options are separated in types and specs, as follows:

As to the expiration

American Options

An American option can be exercised for a named price at any moment before the expiration date. That means you don’t need to wait until the expiry date for taking an action on them, if you want so. Bovespa’s options are American.

European Options

Contrary to the American, Euro options can be just exercised by the expiry date, not before that.

As to the pricing

Call In-The-Money (ITM)

When the current share prices exceed the strike price named in the option. For example, if a VALE share is quoted at BRL40.00, all options with lower strikes are ITM options: VALEA38, VALEA36, VALEA34, etc. The higher ITM option gets, the higher will be the premium.

Call At-The-Money (ATM)

When strike prices for the option are equal to current share prices. Example: if VALE share are being traded at BRL40.00, VALEA40 will be a possible ATM option.

Call Out-of-The-Money (OTM)

When current share prices are lower than strike price named in the options. Again, if VALE shares are quoted at BRL40.00, VALEA42, VALEA44, VALEA46 would be all OTM Calls. The higher the OTM options pricing gets, the lower will be premium charged for them.

Put In-The-Money (ITM)

When the current share prices are lower than the strike price named in the option. For example, if a VALE share is quoted at BRL40.00, all options with higher strikes are ITM options: VALEM42, VALEM44, VALEM46, etc. The higher the ITM option gets, the higher will be the premium.

Put At-The-Money (ATM)

When strike prices for the option are equal to current share prices. Example: if VALE share are being traded at BRL40.00, VALEA40 will be a possible ATM option.

Put Out-of-The-Money (OTM)

When current share prices are higher than the stirke price named in the options. Again, if VALE shares are quoted at BRL40.00, VALEM38, VALEM36, VALEM34 would be all OTM Calls. The higher the OTM options pricing gets, the lower will be premium charged for them.


6. Pricing

There are a number of pricing structures for options. We based our calculations in the most famous – the Black & Scholes model.

Black & Scholes calculates a fair pricing for options. It takes 5 different variables that affect prices, and use greek letters as follows:

Delta

Delta determines how sensitive to share prices the premium can be. If share prices hike by BRL1.00, options prices are also up, although not in the same pace. Delta looks for finding such proportion. Usually, it varies between 0 and 1 for Calls and between -1 and 0 for Puts.

Gamma

Gamma stands for Delta’s variations compared to share prices. It is a risk measurement, showing possible chances of losses or gains based on share prices. A higher Gamma implies that Delta is more likely to change when shares float.

Vega

Vega measures how sensitive an option can be to shares volatility. This factor returns the options exposure to each change of 1% in implied volatility in the shares market.

Theta

Theta measures an option sensitivity as the time goes by. As time goes by and the expiry date comes closer, options prices drop. That happens because the nearer we are from the expiration date, the easier becomes to guessing what the share prices will be.

Rho

Rho shows the option sensitivity to interest rates (Selic, in Brazil). Rho is seen as the least important factor in Black & Scholes model, because when the interest rate changes, the option price does not chance that much. The more distant an option is from its expiry date, the more exposed it is to interest rates and external factors. This is due to the fact that if interest rates rise, the opportunity cost of maintaining an immobilized amount of an option also rises because it is always possible to make other investments yielding interest rate risk free.


7. Risks

Share options can either increase the exposure to risks or reduce it. They will increase risks if you use them as a way of leveraging assets, but should reduce if you use them as hedging tool.

For instance, if you sell options to a share that you actually don’t have. By the expiry date, you’ll be forced to deliver those shares to the investor who bought the options, if that pays off to him. Thus, imagine that you sold 1,000 options. By the expiration date, if the buyer exercises his rights, you’ll be forced to purchase 1.000 shares and sell them to him for the strike price. Can you imagine how big you losses will be?

Opposingly, investing in options can be an alternative for those who want to invest in shares, but have no big cash for that. As options prices are significant lower than those for shares, you can buy some options if you think the shares are going up. For instance, a Petrobras option is worth BRL0.20, with expiration date for 20 days from now. You can acquire 1,000 of them, spending only BRL200.00. If share prices increase by BRL1.00, by the expiry date, you can exercise your rights, making profits of BRL800.00. However, if share prices drop, your losses are limited to the BRL200.00 invested in options.

The investor can also use the options as hedge. For example, if he gets 1,000 shares of Petrobras, he can also sell the same quantity of options, earning a small amount from doing that, or BRL0.20 per share, a total of BRL200.00 (premium). He protects his position against drops.

Risks for investing in options are related to the strategy adopted by the investor. So, as long as he knows exactly what he is doing before making a move, that can be an invaluable tool for dealing with shares.


8. Taxation

Taxes are due over the profits made while trading or exercising an option. Income tax rate stands at 15%, and the investor himself is responsible for paying that. There is no exemptions, and either the seller or the buyer are entitled to pay it.


9. Advantages

  • Chances of leveraging with a lower amount;
  • Possibility of hedging investments on shares;
  • Chances of high profits;
  • Investing in shares with a lower amount of money;
  • Possibilities of closing positions at any time.

10. Disadvantages

  • Options are not covered by the guaranty fund;
  • High risk;
  • Chances of losing the totality of the investment or even more;
  • Severe problems for those who are not acquainted with the market;
  • Selling positions require a guarantee from brokers;
  • Low liquidity for some shares.

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