Options (Finance)

Options are securities exchange instruments traded on the over-the-counter (OTC) market. Also known as forward contracts.  Options traded on the OTC offer faster than usual investor payoff. The Black-Scholes Model applied to options trading estimates the “cumulative” normal distribution function.  

Options and binary options contracts are considered non-standardized exchange between two parties. Assets are traded at a specified price and expiry date. The “buy” and “sell” of an options contract shows that the holder or seller of the options contract has transferred the underlying value of the security to the buyer. Often cited as exchange traded solution to diminishing returns on portfolio liquidity, options are popular with investors seeking quick liquidity.

Forward contracts are derivatives securities with an underlying value that has the potential to increase during the process of same day exchange. Brokers conducting “call” and “put” operations on the secondary market may trade a variety of options contracts, including those with an underlying value of bonds; commodities; currencies; equities; futures; indices; swaps. Binary options or exotics are “paired” options valued contracts, offering better than average investment returns.

In the past several decades, the trade in options securities has become more complex with exchange traded funds (ETFs), adding variance to the underlying value of those contracts. With high exposure comes increased risk/returns, which makes OTC trading riskier than other “buy” and “sell” exchange. Options contracts are sold at a specified strike price on or before end of contract date

The payoff structure in options trading results in an “asset or nothing” or “cash or nothing” transfer. Cash or nothing options trades are typically fixed cash dividends. In asset or nothing trades the expiry date determines the timing of the exchange required for redemption of the total value of principle, plus whatever has been earned on the market.

Options contracts offer enhanced flexibility for investors seeking returns from debt securities (i.e. bond) agreements. Contract terms and conditions not met with a specified strike price by the specified maturation date can “null and void” a contract, making options trading a risk. Brokers must be knowledgeable about expiry restrictions resulting in a demand for “call” and “put” of an options contract the same day.

For example, the call option formula is calculated by multiplying the contract price by the cumulative standard normal probability distribution function. In other words, the net present value (NPV) of the strike price multiplied by the cumulative standard normal distribution is subtracted from the former. The Black Scholes formula defines the risk probability of a trade: S = initial stock price, K = strike price, T = time to maturity, q = dividend rate, r = risk-free interest rate to volatility. 

C=^rtN(d₂) — Ke^rtN(d₂)

Risk estimation of dividend yield, funding rate, and market volatility by financial analysts and stock traders working on the markets predicts the long forward payoff and short forward payoff of an options contract. The forward position value at time of contract expiry exhibits the difference between the delivery price, and the underlying price at maturity. Daily margin calls help to reduce counterparty risk. Margin calls protect contracts from default associated with credit worthiness or delivery price.

Binary options are considered an exotic class of derivatives that is based on a paired options contract. The nature of the transaction and the trading platform are the main distinctions between the two financial instruments. Traditional options are settled by way of clearinghouse. The strike price is conferred at the time of actual buy or sell. It is the exercise or lapse at time of expiry that creates value for traditional or standard contract options.

Unlike the publicly traded traditional derivatives contracts, binary derivatives contracts are benchmarked or valued on assets, yet are solely proxy to the sell or purchase of the asset itself. Exotics are valued on whether they have expired “in” or “out” of money. Almost any value can be used to peg a price on an underlying asset or portfolio of assets. The danger is that expiry on a contract generally requires the sale of a contract immediately after purchase.

Profit or loss, then, is based on a short valuation of an underlying asset and its performance. Binary derivatives contracts normally must be exercised within one hour. Fixed contracts have a short turn around designated on binary options contracts, and little flexibility is available to traders should they decide to transfer.

Purchase of a binary derivatives contract normally requires research of an underlying asset at the time of tender. The risk is that value on the underlying asset may increase or decrease prior to contract expiry, “Call” or “Put.” At time of contract expiry, if a prediction has closed ‘in’ the money, a fixed payout is the result. If a purchase does not perform as expected, the investor will be ‘out’, but only sustain a fixed loss.

The key difference, then, between a binary derivatives contract and a traditional derivatives contract is that investors have the time to review the performance of an underlying asset over an extended period. Exercise of buy or sell of the derivative can be measured daily.  Whether trading traditional options contracts or binary options contracts, there is always some risk to investment returns.

Options instruments and their trading platform are normatively scaled by their expiry date. Decisions to ‘call or put a contract may be limited when short intervals are present. In the case of binary options contracts, fixed payouts make for untold results. The value of an underlying asset is typically risky when it goes to the OTC market, yet the probability of loss on a binary derivatives contract is weighted by the higher payout if the contract should perform.

Preference for some underlying assets over others is generally defined by knowledge of performance preceding earlier payouts. Binary contracts, regardless of purchase price, offer profits that are relatively fixed. Traditional derivatives contracts, on the other hand, are risky in terms of longitudinal instability but have a more extended period to maturity.

For brokers and other OTC traders, Insight into market currents is critical for making the right decision about purchase of options contracts. Research of underlying assets prior to purchase is key. There is some evidence blended portfolios benefit from the scaling of risk probability based on historical performance of similar securities.

For students enrolled in a Finance program, the study of Options trading is a dynamic experience requiring an understanding of Calculus. Training in Algebra and Statistics is a pre-requisite to achieving this objective.

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Bibliography

“Options.” Investopedia. 

OTC Markets.

“The Black Scholes Model.” Investopedia. 

Melendez, Steven. "What Makes the Over-the-Counter Market Different from the NASDAQ or the New York Stock Exchange?" Zacks, Feb 6, 2019.