An option is a contractual agreement entered into by two parties – a seller and a buyer- giving the buyer the right and not the obligation, to purchase or sell a commodity at a later date at an already agreed upon price today. See option as ‘freedom to either do a thing or not to do it’
Notice the use of the word ‘right’ and not ‘obligation’. What this means is that a buyer or seller can at anytime before the expiration of the contract decide to back out without incurring any legal action upon him or her self. Buyers seem to be favored more in option trading than the sellers. The option seller is ready to sell or buy according to contract terms if and whenever the buyer so desires.
What the buyer of an option pays the seller of the option is known as the price or premium.
A CALL is used to describe an option made for buying something while a PUT is used to describe the option made for selling something.
DO OPTIONS HAVE AN ORGANIZED MARKET?
In as much as options trade in an organized market, the fact still remains that large amount of options trading are done privately over the counter. Organized options exchange was created in 1973, but that does not stop people from privately contracting with each other to trade options.
HOW ARE OPTIONS PRICED?
Options are priced with help of models. A model is a simple way of representing an otherwise complex realities; making use of certain inputs to produce verifiable output. This can be done manually or by the use of electronic devices such as computer. An option pricing model makes use of inputs from known variables to get output – theoretical fair value of the option. Various models exist but the most common ones are: (1) binomial option pricing model, and (2) Black-Scholes options pricing model.
I hope you got what you are looking for from this post. Please let me know what you think about this article. Thanks for reading.
To your successful options trading!
SHORT SELLING; WHAT IS SHORT SELLING OF COMMODITIES?
Short selling of shares is a situation where a seller of stock sells stock that does not belong to him or her. This situation is fairly common in the stock market where a party to stock trading transaction borrows stock from a broker and sells it to a buyer at a higher price hoping that the stock price will fall to enable him to buy back the stock and repay the lender of same. This is sometimes used figuratively to mean one placing his belongings where he or she cannot easily get it back when the need arise.
SHORT SELLING WORKS IN TWO WAYS:
One, you can make a lot of money from it. Yes, short selling can make you a lot of money when you predict right. Imagine how much you stand to gain when you borrow stock that sells at $50 from a stockbroker and sell at the same price only for the stock to fall to around $20 in about two months time. Again, suppose that you were able to borrow up to 10,000 units of such stock. I will leave you to do the mathematics. The profits you make from this can change your car and wardrobe.
Two, you can go bankrupt by this singular act. The exact opposite of what happened above will happen here if it backfires.
Short selling still gains ground in the heart of many in the financial market today despite the highly levered nature of short selling. A lot of people compare short selling with margin trading as they both involve the use of other people’s money to trade the commodity, currency or stock market.
This comparison is not a fair one as one is more risky than the other. The risk of margin trading is cushioned by the ‘stop’ function that is built into many trading platforms that exist today. The stop function allows you to fix a limit to the amount you are willing to stake (expose) in any given trade. Short selling does not give this kind of opportunity to take losses at a certain level. I will leave you to do the comparison yourself.
I only use short selling when I have done my technical and fundamental analysis properly. It is not wise to trade the market sentimentally talk more of doing so when you are shorting. Avoid short selling of stocks if you don’t have reliable financial cushion.
SHORT SELLING WORKS IN TWO WAYS:
One, you can make a lot of money from it. Yes, short selling can make you a lot of money when you predict right. Imagine how much you stand to gain when you borrow stock that sells at $50 from a stockbroker and sell at the same price only for the stock to fall to around $20 in about two months time. Again, suppose that you were able to borrow up to 10,000 units of such stock. I will leave you to do the mathematics. The profits you make from this can change your car and wardrobe.
Two, you can go bankrupt by this singular act. The exact opposite of what happened above will happen here if it backfires.
Short selling still gains ground in the heart of many in the financial market today despite the highly levered nature of short selling. A lot of people compare short selling with margin trading as they both involve the use of other people’s money to trade the commodity, currency or stock market.
This comparison is not a fair one as one is more risky than the other. The risk of margin trading is cushioned by the ‘stop’ function that is built into many trading platforms that exist today. The stop function allows you to fix a limit to the amount you are willing to stake (expose) in any given trade. Short selling does not give this kind of opportunity to take losses at a certain level. I will leave you to do the comparison yourself.
I only use short selling when I have done my technical and fundamental analysis properly. It is not wise to trade the market sentimentally talk more of doing so when you are shorting. Avoid short selling of stocks if you don’t have reliable financial cushion.
EFFECTS OF MARKET EFFICIENCY ON THE THEORETICAL FAIR VALUE OF STOCKS
Market efficiency is a fundamental assumption of in a market where prices of instruments trading on market floors reflects their perceived true economic value to the investors. There are three forms of market efficiency VIZ:
Strong form of market efficiency
Semi strong form of market efficiency
Weak form of market efficiency
Investors cannot consistently beat the market in an efficient economy as prices fluctuate randomly. One cool concept that investors and other financial engineers love to believe is the concept of theoretical fair value.
Theoretical fair value assumes that somehow somewhere out there, there exists real value of commodities. This concept of theoretical fair value makes investors and financial engineers happy because, they believe that lots of money awaits them as they believe to buy very low and sell very high. The only serious problem they however face is how to find the true economic value of instruments.
This problem has however been relieved by yet another model called (CAPM) capital assets pricing model. CAPM is a controversial and highly debated theory whose applicability cannot be verified in practice. The formula to calculate it is:
E(rs) = r + [E(rm) - r]βs
Where E(rs) is the expected return on the market portfolio, which is the combination of risky assets, r represents risk free asset, and βs is called the asset beta. The beta measures unavoidable risk (systematic risk). It is not my intention to fully discuss CAPM in this article as I will give it full treatment while discussing ‘derivatives’.
One cannot possibly appreciate the concept of derivatives without firstly gaining full understanding of CAPM.
All the above concept of theoretical fair value of instruments can only hold true if the market is efficient. Like I explained before, market efficiency deals with how investors and other consumers of financial information and other information incorporate these information into prices of tradable commotidies.
Strong form of market efficiency
Semi strong form of market efficiency
Weak form of market efficiency
Investors cannot consistently beat the market in an efficient economy as prices fluctuate randomly. One cool concept that investors and other financial engineers love to believe is the concept of theoretical fair value.
Theoretical fair value assumes that somehow somewhere out there, there exists real value of commodities. This concept of theoretical fair value makes investors and financial engineers happy because, they believe that lots of money awaits them as they believe to buy very low and sell very high. The only serious problem they however face is how to find the true economic value of instruments.
This problem has however been relieved by yet another model called (CAPM) capital assets pricing model. CAPM is a controversial and highly debated theory whose applicability cannot be verified in practice. The formula to calculate it is:
E(rs) = r + [E(rm) - r]βs
Where E(rs) is the expected return on the market portfolio, which is the combination of risky assets, r represents risk free asset, and βs is called the asset beta. The beta measures unavoidable risk (systematic risk). It is not my intention to fully discuss CAPM in this article as I will give it full treatment while discussing ‘derivatives’.
One cannot possibly appreciate the concept of derivatives without firstly gaining full understanding of CAPM.
All the above concept of theoretical fair value of instruments can only hold true if the market is efficient. Like I explained before, market efficiency deals with how investors and other consumers of financial information and other information incorporate these information into prices of tradable commotidies.
WHAT IS FINANCIAL ENGINEERING?
Financial engineering is the phrase used to represent the study of finance and the development of financial products. The ever changing field of finance and financial services industry constantly give room for more and more financial products are developed. Those that engage in this process is called financial engineering.
HOW TO BECOME A FINANCIAL ENGINEER?
You don’t need physical tools to become a financial engineer unlike other fields of engineering. All you need to become a financial engineer is to acquire the right knowledge that will enable you tweak derivatives and already existing financial products.
Some of the knowledge to become a financial engineer can be found in this blog. So I will encourage you to always visit this hub as I will be sharing my over 6 years financial engineering experiences.
CAREER OPPORTUNITIES IN FINANCIAL ENGINEERING
There are lots of career opportunities that all and sundry can easily tap into. You will agree with me that finance is the hub of every economy.
Risk analyst: the bulk of what you will learn as a financial engineer is based on the study of risk. After all, a derivative which is the backbone of financial engineering is all about risk analysis and management.
Financial analyst: the training you get from the rigorous studies of financial engineering will make a better financial analyst.
Commodity trader (stocks, FOREX, gold, silver, etc): you can decide to be an independent trader of commodities. This is really cool as you don’t have to work for anyone. You go to work whenever you feel like, though caution needs to be your watch word while doing this.
Independent consultant: the knowledge you have as a financial engineer is a highly sought after skill that people are looking for, so try as much as possible to monetize it.
Lecturer / speaker: your consulting engagement can warrant that you pick up a lecturing appointment or speaking engagement.
So, wouldn’t you rather become a financial engineer?
HOW TO BECOME A FINANCIAL ENGINEER?
You don’t need physical tools to become a financial engineer unlike other fields of engineering. All you need to become a financial engineer is to acquire the right knowledge that will enable you tweak derivatives and already existing financial products.
Some of the knowledge to become a financial engineer can be found in this blog. So I will encourage you to always visit this hub as I will be sharing my over 6 years financial engineering experiences.
CAREER OPPORTUNITIES IN FINANCIAL ENGINEERING
There are lots of career opportunities that all and sundry can easily tap into. You will agree with me that finance is the hub of every economy.
Risk analyst: the bulk of what you will learn as a financial engineer is based on the study of risk. After all, a derivative which is the backbone of financial engineering is all about risk analysis and management.
Financial analyst: the training you get from the rigorous studies of financial engineering will make a better financial analyst.
Commodity trader (stocks, FOREX, gold, silver, etc): you can decide to be an independent trader of commodities. This is really cool as you don’t have to work for anyone. You go to work whenever you feel like, though caution needs to be your watch word while doing this.
Independent consultant: the knowledge you have as a financial engineer is a highly sought after skill that people are looking for, so try as much as possible to monetize it.
Lecturer / speaker: your consulting engagement can warrant that you pick up a lecturing appointment or speaking engagement.
So, wouldn’t you rather become a financial engineer?
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