Option Types

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Real Options

What are Real Options?

Real options are a right but not an obligation to make a business decision. The concept of a real option is crucial to the success of a business as the ability to choose the right business opportunity bears a significant effect on the company’s profitability EBITDA EBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company’s profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples and growth Present Value of Growth Opportunities (PVGO) Present Value of Growth Opportunities (PVGO) is a concept that gives analysts a different approach to valuation. Since prices in stock markets are a combination of fundamentals and expectations, we can break down the value of a stock to the sum of (1) its value assuming no earnings reinvested and (2) the present value . A real option allows the management team to analyze and evaluate business opportunities and choose the right one.

The concept of real options is based on the concept of financial options; thus, fundamental knowledge of financial options is crucial to understanding real options.

Types of Real Options

Real options may be classified into different groups. The most common types are: option to expand, option to abandon, option to wait, option to switch, and option to contract.

  • Option to expand is the option to make an investment or undertake a project in the future to expand the business operations (a fast food chain considers opening new restaurants).
  • Option to abandon is the option to cease a project or an asset to realize its salvage value (a manufacturer can opt to sell old equipment).
  • Option to wait is the option of deferring the business decision to the future (a fast food chain considers opening new restaurants this year or in the next year).
  • Option to contract is the option to shut down a project at some point in the future if conditions are unfavorable (a multinational corporation can stop the operations of its branches in a country with an unstable political situation).
  • Option to switch is the option to shut down a project at some point in the future if the conditions are unfavorable and resume it when the conditions are favorable (an oil company can shut down the operation of one of its plants when oil prices are low and resume operation when prices are high).

Pricing of Real Options

The NPV method NPV Formula A guide to the NPV formula in Excel when performing financial analysis. It’s important to understand exactly how the NPV formula works in Excel and the math behind it. NPV = F / [ (1 + r)^n ] where, PV = Present Value, F = Future payment (cash flow), r = Discount rate, n = the number of periods in the future is the most straightforward approach to real options pricing. For example, for an option to expand the business operation, we can forecast the future cash flows of this project and discount them to the present value at the opportunity cost. We will use the option if the NPV is positive and dismiss it if the NPV is negative. However, in a real-life setting, the NPV approach can be hard to perform correctly.

Fortunately, the pricing of financial options approaches can be applied to price the real options. Some real options behave similarly to calls; some behave similarly to puts. As for example, the option to expand can be viewed as a call option, while the option to abandon can be viewed as a put option.

In order to use the techniques for pricing financial options for real options, we should define the relevant variables.

Symbol Financial Option Real Option
S Stock price Expenditure required to acquire asset/Upfront investment
K Strike price Current value of asset/project
T Time to maturity Time before the opportunity expires
σ Volatility Riskiness of asset/project
r Risk-free rate Interest rate
Div. Dividends Cash flows from operations

Using the variables above, we can easily use the methods used for pricing financial options such as binomial model, Black-Scholes model, and Monte Carlo simulation to price real options.

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ FMVA® Certification Join 350,600+ students who work for companies like Amazon, J.P. Morgan, and Ferrari certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

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  • Options Case Study – Long Call Options Case Study – Long Call This options case study demonstrates the complex interactions of options. Both put and call options have different payouts. To study the complex nature and interactions between options and the underlying asset, we present an options case study.
  • Projecting Income Statement Line Items Projecting Income Statement Line Items We discuss the different methods of projecting income statement line items. Projecting income statement line items begins with sales revenue, then cost of goods sold, gross profit, selling general and admin (SG&A), depreciation, amortization, taxes, EBITDA, and net income. This guide has examples
  • Projecting Balance Sheet Line Items Projecting Balance Sheet Line Items Projecting balance sheet line items involves analyzing working capital, PP&E, debt share capital and net income. This guide will break down step-by-step how to calculate and then forecast each of the line items necessary to forecast a complete balance sheet and build a 3 statement financial model.
  • Long and Short Positions Long and Short Positions In investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short).

What are the Different Types of Options Trading Tools?

Real-time trading prices, financial modeling, and an ability to reverse engineer new trading strategies for testing are some characteristics of options trading programs.

  • Written By: Dana DeCecco
  • Edited By: A. Joseph
  • Last Modified Date: 05 March 2020
  • Copyright Protected:
    2003-2020 Conjecture Corporation

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Successful options trading requires an arsenal of options trading tools. The different types of options trading tools are chains, Greeks, graphs, and volatility studies. These four tools are the most important for creating the various option strategies. Without these tools, options trading is nothing more than gambling.

Option chains provide strike prices and option premiums. The premiums are the prices paid for the various strike prices. The strike price is the price at which the contract can be exorcised.

The spread, which is the difference between the bid and ask price, is also on the option chain. Volume and open interest of each individual option can provide the trader with market sentiment information. Option chains are sorted by expiration month.

Option Greeks are necessary to determine many factors that affect the value of the contract. Delta is used to calculate the the value of the option in relation to the movement of the spot price of the underlying asset, and gamma calculates the relation of delta to movement in the underlying spot price. Vega calculates the value of the option in relationship to implied volatility. Theta is the actual loss in time value as the option approaches expiration, and rho determines the value in relation to interest rates. When put together, the Greeks determine the value of an option contract.

Option graphs can be an invaluable asset in the arsenal of options trading tools. They are a visual tool, and many traders respond well to visual trade interpretations. Graphs will show the value and outcome of the trade under various market conditions. A change in implied volatility will alter the outcome of the trade.

Time until expiration affects option value. The price change of the underlying asset is of prime importance. All of these factors can be charted in graphical form.

Volatility studies should be analyzed before the option position is entered. The general rule of thumb is that one should buy low volatility and sell high volatility. Implied volatility in relation to historic volatility and in relation to recent historical data can be charted. The option trader can get a sense of the general direction and anticipate future directional movement on the volatility chart. These different types of options trading tools are available from various sources.

Advisory services also might be considered an options trading tool. Advisory services are available by subscription. Options trading software can be quite expensive to purchase. Software might be offered by the options brokers for free with an account. Many software programs are available for free on various websites.

Options Contract

What Is an Options Contract?

An options contract is an agreement between two parties to facilitate a potential transaction on the underlying security at a preset price, referred to as the strike price, prior to the expiration date.

The two types of contracts are put and call options, both of which can be purchased to speculate on the direction of stocks or stock indices, or sold to generate income. For stock options, a single contract covers 100 shares of the underlying stock.

The Basics of an Options Contract

In general, call options can be purchased as a leveraged bet on the appreciation of a stock or index, while put options are purchased to profit from price declines. The buyer of a call option has the right but not the obligation to buy the number of shares covered in the contract at the strike price.

Put buyers have the right but not the obligation to sell shares at the strike price in the contract. Option sellers, on the other hand, are obligated to transact their side of the trade if a buyer decides to execute a call option to buy the underlying security or execute a put option to sell.

Options are generally used for hedging purposes but can be used for speculation. That is, options generally cost a fraction of what the underlying shares would. Using options is a form of leverage, allowing an investor to make a bet on a stock without having to purchase or sell the shares outright.

Call Option Contracts

The terms of an option contract specify the underlying security, the price at which that security can be transacted (strike price) and the expiration date of the contract. A standard contract covers 100 shares, but the share amount may be adjusted for stock splits, special dividends or mergers.

In a call option transaction, a position is opened when a contract or contracts are purchased from the seller, also referred to as a writer. In the transaction, the seller is paid a premium to assume the obligation of selling shares at the strike price. If the seller holds the shares to be sold, the position is referred to as a covered call.

Put Options

Buyers of put options are speculating on price declines of the underlying stock or index and own the right to sell shares at the strike price of the contract. If the share price drops below the strike price prior to expiration, the buyer can either assign shares to the seller for purchase at the strike price or sell the contract if shares are not held in the portfolio.

Key Takeaways

  • An options contract is an agreement between two parties to facilitate a potential transaction involving an asset at a preset price and date.
  • Call options can be purchased as a leveraged bet on the appreciation of an asset, while put options are purchased to profit from price declines.
  • Buying an option offers the right, but not the obligation to purchase or sell the underlying asset.
  • For stock options, a single contract covers 100 shares of the underlying stock.

Real World Example of an Options Contract

Company ABC’s shares trade at $60, and a call writer is looking to sell calls at $65 with a one-month expiration. If the share price stays below $65 and the options expire, the call writer keeps the shares and can collect another premium by writing calls again.

If the share price appreciates to a price above $65, referred to as being in-the-money, the buyer calls the shares from the seller, purchasing them at $65. The call-buyer can also sell the options if purchasing the shares is not the desired outcome.

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