We had pointed out back in February as to how startups are disintermediating banking and that given the amount of data that both banks and Facebook have on us, it is only a matter of time that we saw a “Facebook National Bank.” Turns out that it is now a reality:
Facebook is readying itself to provide financial services in the form of remittances and electronic money. The social network is only weeks away from obtaining regulatory approval in Ireland for a service that would allow its users to store money on Facebook and use it to pay and exchange money with others. “Facebook wants to become a utility in the developing world, and remittances are a gateway drug to financial inclusion.”
The first rule of trading options is that options are not stocks. Just because the underlying stock moves doesn’t mean that the option moves in the same direction. You need to think of options as a separate asset class.
For example, if you are in a ship at sea, you know that the tides are linked to the phases of the moon. But the tides are only a small part of what is involved in sailing, isn’t it? You should also know about ocean currents, developing weather patterns, presence of icebergs, reefs, etc… Similarly, the option premium is only lightly tethered to the value of the underlying.
The key thing to remember is that the option premium is a function of intrinsic value, time value and volatility.
Lets say you buy a April NIFTY 6750 Call @ Rs. 59.70 when the NIFTY was trading at 6733.10. Say, the NIFTY rallies by 1% to 6800.431 the next minute. Would your call option also increase by 1%? Nope. It will probably tick up by 0.5% Why? because the delta(δ) of that option is 0.49
But what if the NIFTY rallies tomorrow by 2%. Will your call option premium now increase by 1%? Nope. There are two opposing forces that are now acting on the option.
The first, and the strongest force, is time decay. It is known to crush the best laid plans of both men and mice.
It is not only important to mind your greeks at the time of putting on the trade, but you need to monitor it constantly. Greeks change not only as the underlying moves, but also as expiration approaches.
The ability of forecasters to predict turning points is limited. Forecasts from the official sector, either from national sources or international agencies, are no better at predicting turning points.
So the explanation for why recessions are not forecasted ahead of time lies in three other classes of theories, which are not mutually exclusive.
One class says that forecasters do not have enough information to reliably call a recession. Economic models are not reliable enough to predict recessions, or recessions occur because of shocks (e.g. political crises) that are difficult to anticipate.
A second class of theories says that forecasters do not have the incentive to predict a recession, which – though not a tail – event are still relatively rare. Included in this class are explanations that rely on asymmetric loss functions: there may be greater loss – reputational and other kinds – for incorrectly calling a recession than benefits from correctly calling one.
The third class stresses behavioural reasons for why forecasters hold on to their priors and only revise them slowly and insufficiently in response to incoming information.
A more than a healthy dose of skepticism is always warranted when dealing with these so called “expert forecasts.”
The first options were used in ancient Greece to speculate on the olive harvest. It was mid-winter, and the owner of the olive presses was happy to sell the right to use the olive presses during the harvest season. It generated income for the olive press owner during the off season.
The man purchasing the rights ensured that he would have use of the presses during the busy season. If the olive harvest was really good, the purchaser might be able to even resell his right to use the olive presses for a profit.
The stock options of today appear to have made their debut in what were described as “bucket shops”. It wasn’t until 1973 that the modern financial options market came into existence. The Chicago Board of Trade (CBOT) opened the Chicago Board Options Exchange (CBOE).
Option pricing
The option premium is a function of intrinsic value, time value and volatility.
Intrinsic value: The intrinsic value of an option is the difference between the actual price of the underlying security and the strike price of the option. The intrinsic value of an option reflects the effective financial advantage which would result from the immediate exercise of that option.
Time value: It is determined by the remaining lifespan of the option and the cost of refinancing the underlying asset (interest rates).
Volatility: Higher volatility implies higher premiums as the probability that the option will expire in-the-money increases with volatility.
Some heuristics used to come up with a price for an option:
make sure put-call parity is respected
a call of a certain strike K cannot trade at a lower price than a call K+ΔK (avoidance of negative call and put spreads)
a call struck at K and a call struck at K+2ΔK cannot be more expensive than twice the price of a call struck at K+ΔK (negative butterflies)
There are theoretical option-pricing models, the most popular being Black-Scholes-Merton (BS), that can be used to price options. However, the primary use of BS in the real world is to trade the greeks.
This Khan Academy video does a good job of explaining the BS model:
Put-Call Parity
The put-call parity states that a portfolio of a long call option and a short put option is equivalent to (and hence has the same value as) a single forward contract at this strike price and expiry.
The intuition behind this is: Call + Cash = Put + Underlying Asset
The put-call parity provides a simple test of option pricing models. Any pricing model that produces option prices which violate the put-call parity is considered flawed.
Options on StockViz
The BS Model greeks for “on the run” strikes (strikes closest to the underlying) are available for all listed options on StockViz. These values are updated on the fly using the latest market information.
You can place (dummy) trades by clicking on the green button. This will allow you to track your options P&L over the life of the trade.
The following are excerpts from a recent JP Morgan special report titled “India: elections, markets & the tyranny of economic reality.”
The equity market exuberance, however, appears based on opinion polls increasingly pointing to a stable government post election, and the presumption of a dramatic economic pivot post election that jump starts a new capex cycle.
The broad hope is that a positive cycle can be unleashed if projects get unclogged, increasing cash flow for infra companies (which account for 30% of stressed loans), enabling loan repayments, and healing bank balance sheets, which can allow a fresh lending cycle to start.
But the problem is that the vast majority of projects are currently stuck because of issues that are under the purview of state governments, over which the central government has little jurisdiction.
And even if these problems were magically resolved, where is the money going to come from? Among the BSE-200 non-financials, 17% have operating incomes (before depreciation, interest and taxes) that are less than the perilous threshold of 1.5 times their debt service obligations. So a significant deleveraging would need to be undertaken before these infrastructure companies have the balance sheet strength to finance another investment cycle. This is a multi-quarter process.
Banks are not in a position to lend. Public sector banks – which account for 70% of banking sector assets – are saddled with the overwhelming majority of impaired loans, and would need a significant quantum of capital injection by the government – far in excess of what has been budgeted – to finance any large pick-up in credit growth.
Given the economic reality on the ground, the translation from political stability to economic performance is likely to be far more lagged, incomplete and uncertain than the current market euphoria may be betraying.
