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Derivative Securities and Stock Options

According to Block & Hirt (2002), securities are called derivative when their value derives from the price of another asset such as common stocks, bonds, commodities and so the like; in other words, their cash flows depend on the prices of other assets. Derivatives are a form of agreement or declaration between two parties. It contains the conditions and specifications related to the underlying asset. Derivatives are used to mitigate risk such as the decline in value of a portfolio. They consist of a wide number of financial figures such as options and futures. The most commonly used derivative security is the option (Block & Hirt, 2002).

Options

            Berk, DeMarzo, & Harford (2009) explained that an option is a contract that entitles the holder to acquire or market an underlying security at a determined value for a given period of time. That contract is between the holder or owner of the financial option and the option writer which is the seller. Option traders use certain terminology or words to write the contractual obligations. Some of those terms are: (1) strike or exercise price. It is the predetermined value at which the option holder could exercise the option; (2) exercising the option. It occurs when the option holder enforces the rights given by the contract; (3) the expiration date. It is the maturity date or the last day to exercise an option. Not all options could be exercised anytime during its life time. The authors identified two kinds of options depending on their expiration dates. One is called American option and is the most common one. Its holder could exercise it any time before or on its maturity date. The second one is the European option which allows its owner to exercise it only on the expiration date. It is generally accepted that the expiration day of the options must be the third Saturday of the month. It must be said that the name given to these last two options (American and European) is not related to the continent where they are traded because both are exchanged globally (Berk, DeMarzo, & Harford, 2009).

Berk et al. (2009) affirmed that the most frequently used option is the option on shares of stock. Many companies compensate their outstanding employees with stock options. These kinds of options are called warrant because the option writer is the company itself. They are very much appreciated by employees because if the company does well and its stock price rises, employees could gain a lot of money.  For instance, an employee may be rewarded with an option to buy 100 shares of stock from the company at $50 each. If the market price – also called option premium – of stock rises to $200 before the maturity of the option; the employee could exercise the option by purchasing 100 shares of stock from the company for $5,000 which the option strike price. If he re-sells them for the market price which is $20,000 in total, he would gain $15,000 = $20,000 – 5,000. Whenever the option market price is greater than the option strike or exercise price, the option is said to be in-the money. It means that the holder obtains gains by exercising the option. On the contrary; when market price is less than the strike price, the option is called to be out-of-the-money which means that the result of exercising the option is a loss of money (Berk et al., 2009).

            Call option.

            There are two basic types of option contracts which are call options and put options (Wild & Shaw, 2011). Ehrhardt & Brigham (2010) defined a call option as a contract that entitles the holder to acquire assets at a determined price for a definite period of time. Call and put options are commonly traded between third parties or independent investors; therefore the company does not participate in the transactions. These types of derivatives differ from an employee stock option contract in which the company is the option writer. Similar to bonds, common and preferred stocks and other securities, options can be freely transfer on exchange markets. The leading market for buying and selling options is the Chicago Board Options Exchange. The call option is associated with a high level of risk because the buyer pays a fee hoping that the market price of the stock rises in order for him to gain. For instance, an option writer (the seller) assures that he will sell you 10 shares of stock at $50. You, as option buyer, would pay a premium of $3 per share (or $30) to the writer for the rights to buy stocks at $50. If the stock closes at $40 – which is less than $50 – on the expiration date, the writer would keep $30 that you would pay in advance for the option while you would loss $30. Based on the past example, it must be concluded that the price of a call option is correlated with the instability of the underlying asset. In other words, the greater the asset’s instability, the higher the price of a call option (Ehrhardt & Brigham, 2010).

            Put option.

            Block et al. (2002) described the put option as an agreement to vend securities to the option writer at a pre-determined value during a definite life time. It is then the contrary side of a call option. In this case, the put writer is the option buyer, while the option seller is the owner. This security is used when the owner expects that the price of the underlying asset will fall. So, in order to mitigate the risk of a possible loss, he pays a fee to the buyer for the right to transfer or sell to the buyer the asset at a fixed price.  For example, if the put owner holds an option to sell the stock at $100, the stock would be only sold if the market price falls below $100. If that happens, the put owner would effectively cover the loss while the option buyer would lose money because he would be force to buy an asset at a price that is higher than the market price. As a put option is a risky derivative, the price of it increases while the volatility of the underlying asset increases. The put option is a kind of insurance that protects investors such as pension funds against falling securities prices (Block et al., 2002).

References:

Berk, J., DeMarzo, P. & Harford, J. (2009). Fundamental of corporate finance. Boston, MA: Pearson Education, Inc.

Block, S. & Hirt, G. (2002). Foundations of financial management. New York, NY: McGraw-Hill/Irwin.

Ehrhardt, M. & Brigham, E. (2010). Corporate finance. Ohio, OH: South-Western Cengage Learning

Wild, J & Shaw, K. (2011). Fundamental accounting principles. New York, NY: McGraw-Hill/Irwin.