How to use options wisely Arif Mansuri of Bank of America Merrill Lynch explains the different types of options investors can buy depending on their market outlook, and outlines issues which affect how options are priced. Link to video for this interview Link to article for this interview Link to continuous education test Interview Arif Mansuri Date: July 2010 Category: Product Training View the profile & other content for Tags: Options, Call option, Put option, Premium, Pricing, Credit risk, Leverage, Volatility Arif Mansuri Call options are the simplest product for investors looking for leverage; investors with a more defined view should use a call spread to reduce the price of the option Put options enable investors to protect themselves against the downside of an underlying stock or index Investors can use collars when they think an underlying stock is expected to be range-bound Advisers selling structured products to investors should present different scenarios as to how the product will perform under different conditions, as well as focus on the soundness of the counterparty The key factors which affect option pricing include: the movement of the underlying stock price, the strike price, time to maturity, volatility, and the riskfree rate Page 1 of 1 If investors want to protect themselves on the downside – because they think a stock will go down by a maximum of 25% – they can buy a put spread rather than an outright put, he added. Mansuri said that another common structure exists where investors think an underlying stock is expected to be range-bound, and they want to protect their position. They can then use a collar – where they are effectively buying a put and selling a call, designed so that the option premium investors pay is zero. Investors then get the spread rather than anything beyond the strike on the put or call. Common mistakes Options seem to look attractive to investors – which Mansuri said is the case because all the risks are not always clearly explained. When selling structured products to investors, therefore, he said advisers should present different scenarios as to how the product will perform under different conditions. If this is done, the chances of misselling or mis-understanding are reduced. Using options In addition, when investors are buying a call option or a structured product, he said they are always taking a credit risk. So they should look at who is the counterparty, whether that institution is sound and well-capitalised. For investors looking for leverage, the simplest product to buy is a call option, said Arif Mansuri in an interview. Option pricing If the call option is expensive, then buying Asian call options – which means averaging maturity – can effectively cheapen the overall price, he added. On the other hand, for investors looking to protect themselves against the downside of an underlying stock or index, Mansuri said they should buy a put option. Drilling down further, he explained that if investors have a more defined view on how the underlying will perform – for example if they think it will go up by a maximum of 20% in one year – the best way to express that view is not generally through buying a call option, since this might be expensive given that the option seller is also giving you upside beyond the 20% increase. Instead, the right product to express the view would be a call spread. This is where an investor buys an at-the-money call option and sells an out-of-the-money call option at 120, he explained. The option premium that the investor pays is therefore much lower than would have been paid on a call option, enabling the investor to express their view in a more effective way. If after one year the underlying is up 15%, the investor in a call spread gets paid out 15%, said Mansuri, with anything beyond a 20% upside retained by the option seller. According to Mansuri, there are various key factors which affect option pricing. First is the movement of the underlying stock price. So if investors are buying a call option and the underlying stock price goes up, the option gets more in-the-money, and vice versa for put options, he explained. Secondly, he said, the strike price is an important factor in determining the option pricing. If the underlying is priced at 100 and investors are buying at-the-money, it is likely to be more expensive than if they were buying it out-of-the-money at 90. Thirdly, time to maturity is an important factor affecting option pricing. For example, said Mansuri, three-year options are more expensive than one-year options as investors have more chance of making more money as an option-buyer with a longer maturity product. Fourthly, volatility is a key parameter in option pricing. The more volatile the option the higher the chances it will go up, he explained. Fifthly, the risk-free rate plays a role in option pricing, he said. So if interest rates are higher, the forward is likely to be higher, so call options will be more expensive. Do you have any comments? Contact the editor: T 852 2792 7707 E editor@hubbis.com W www.hubbis.com © Hubbis (HK) Limited 2010 Disclaimer