Investment Analysis – Options, Hedging and Speculation

This piece of work will focus on options, hedging and speculation in the vast field of securities. Knowing that many investors’ portfolios include investments such as mutual funds, stocks and bonds, we know that the variety of securities does not end here. Empirical literature suggest that “options are a type of security that present a world of opportunity to sophisticated investors”, these securities are complex and can be extremely risky for investors. In 2007, we saw the beginning of the financial crisis starting with the collapse of Lehman Brothers, one of the main leaders in the derivatives market, where many investors lost large amounts of money, mainly because they were unaware of the complexity of structured products that were offered to them by consultants of merchant banks and the credit ratings by the issuers. Since then, issuers try to create more transparent products for the average investor and simultaneously, these investors seek for issuers with a relatively stable creditworthiness after the incidents in the recent past. Thus, it is our objective to explain this topic, in the form of presentation and essay, as easy as possible to our audience.

The essay will be divided into 3 core sections including a stream of literature for each section. At the beginning, options will be defined including several examples. We will be looking at stock options, calls & puts, participants in the options market and key distinctions between buyers & sellers. Further on, this will be followed by the hedging and speculation section whereby several option strategies will be examined. Afterwards, we will emphasize on the put-call parity relationship. Subsequently, option valuation will be covered mainly by focusing on the Binomial Model and the Black-Scholes-Model which will include pricing examples. Finally, hedging and speculating on mispriced options will be briefly explained.

As previously signified, we know that options are complex and risky securities that are/should be ideally suited for sophisticated investors who hold large stock portfolios. Kolb & Overdahl (2007)^[1] support this fact with their argument that “by trading options in conjunction with stock portfolios, investor can carefully adjust the risk and return characteristics of their entire investment.” Prior to the financial crisis, the general public perceived them as risk-neutral whereas now investors pay more attention to their portfolio, explicitly the selection of financial instruments. But even at that time, well-experienced professionals in the industry realized that derivative instruments also hold the potential of being misused. Warren Buffet^[2], Chairman of Berkshire Hathaway, highlighted that derivatives are “time bombs” and they are “financial weapons of mass destruction” since risk can be transferred from those who do not want it to those who are willing to accept it for a price (Kolb & Overdahl, 2007)^[3] – this is where a market is created. Kolb & Overdahl (2007) also mentioned that “derivative instruments offer an efficient mechanism for financial institutions, commercial enterprises, governments and individuals to hedge preexisting risk exposures” implying that derivative instruments do offer several benefits to the economy and outweighs the misuses. It is a well- known fact that investors trade options in order to speculate on certain price movements of the underlying asset e. g stocks. The question arises why not trading with stocks rather than options? The answer is that call options are cheaper than the underlying, hence, it takes less money to trade calls – generally, the same applies with puts. Kolb & Overdahl (2007)^[4] add that “in relative terms, the option price is more volatile than the price of the underlying stock, thus, investors can get more price action per dollar of investment by investing in options instead of investing in the stock itself.”

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