Monday, May 18, 2009

Options Review, Pt 1 - Underlying Asset

[Options Review Series 1 - 2 - 3 - 4 - 5]

While it would appear to be a misnomer for the inaugural post to start with underlying asset, I wanted to show a few graphs and tools related to movement in the underlying asset in today's posts about derivatives to build a foundation on which to describe other option based derivatives. Using the tools and short graphs presented in today's series, there should not be any learning outcome statement (LOS) on the CFA Level I exam relating to options based derivatives which can't be tackled.

Let's start with the position most people are familiar with: Being Long the underlying asset (buying something).
Obviously, as the value (St) goes up, so does the value of the asset. And if St is greater than S0 (purchase price), then you've made a profit. If it goes down below S0, you've taken a loss.

Long Underlying Asset Profit = St - S0

Now let's look at short selling. Short selling is the exact opposite of being long the underlying asset. In short selling, you borrow the stock from a broker, sell it on the open market, and repurchase it later in the hopes that the price will drop (rather than go up).
Short Underlying Asset Profit = S0 - St

A few interesting notes about short selling. Unlike being long a security which technically involves only two parties (yourself and the market), being short also includes the broker who lends you the stock. In being short a stock, all dividends paid by the stock while you hold it need to be paid by you to the broker. It's as if the broker still has it (they own it even if they don't currently hold it).

Interestingly, if you add the two graphs together, (Long Underlying Asset and Short Underlying Asset) there is no profit. The profit area under one graph cancels the loss area of the other. That is to say, the profit in the Long is the loss of the Short and visa versa.

Now capitalists being what they are, there is a fee which is associated with incentive for the broker for you to perform this action, but this is outside the scope of CFA Level I.

Also note that shorting is only permitted on "upticks" or flat prices where the previous tick was an uptick. What does this mean? Consider the following 5 prices in order: [52, 51, 53, 53, 50]

Short selling is not permitted on the:
  • 2nd tick (a downtick from 52 to 51)
  • last tick (a downtick from 53 to 50)
Short selling is permitted on the:
  • 3rd tick (an uptick from 51 to 53)
  • 4th tick (a flat tick at 53, preceded by an uptick from 51 to 53)
I did wonder, however, if you had an uptick followed by a series of flat ticks if you were still able to short sell. I would assume the answer is yes, since the underlying reason is to prevent short sellers from aggressively depressing the stock price, but this is also outside of the CFA Level I curriculum.

[Options Review Series 1 - 2 - 3 - 4 - 5]

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