How to use options wisely Interview Arif Mansuri

How to use options wisely
Arif Mansuri of Bank of America Merrill Lynch explains the different
types of options investors can buy depending on their market
outlook, and outlines issues which affect how options are priced.
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Interview
Arif Mansuri
Date: July 2010
Category: Product Training
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Tags: Options, Call option, Put option, Premium, Pricing, Credit risk, Leverage, Volatility
Arif Mansuri
Call options are the simplest product for investors
looking for leverage; investors with a more defined
view should use a call spread to reduce the price of
the option
Put options enable investors to protect themselves
against the downside of an underlying stock or index
Investors can use collars when they think an
underlying stock is expected to be range-bound
Advisers selling structured products to investors
should present different scenarios as to how the
product will perform under different conditions, as
well as focus on the soundness of the counterparty
The key factors which affect option pricing include:
the movement of the underlying stock price, the
strike price, time to maturity, volatility, and the riskfree rate
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If investors want to protect themselves on the downside – because
they think a stock will go down by a maximum of 25% – they can buy a
put spread rather than an outright put, he added.
Mansuri said that another common structure exists where investors
think an underlying stock is expected to be range-bound, and they
want to protect their position. They can then use a collar – where they
are effectively buying a put and selling a call, designed so that the
option premium investors pay is zero. Investors then get the spread
rather than anything beyond the strike on the put or call.
Common mistakes
Options seem to look attractive to investors – which Mansuri said is
the case because all the risks are not always clearly explained.
When selling structured products to investors, therefore, he said
advisers should present different scenarios as to how the product will
perform under different conditions. If this is done, the chances of misselling or mis-understanding are reduced.
Using options
In addition, when investors are buying a call option or a structured
product, he said they are always taking a credit risk. So they should
look at who is the counterparty, whether that institution is sound and
well-capitalised.
For investors looking for leverage, the simplest product to buy is a call
option, said Arif Mansuri in an interview.
Option pricing
If the call option is expensive, then buying Asian call options – which
means averaging maturity – can effectively cheapen the overall price,
he added.
On the other hand, for investors looking to protect themselves against
the downside of an underlying stock or index, Mansuri said they should
buy a put option.
Drilling down further, he explained that if investors have a more
defined view on how the underlying will perform – for example if they
think it will go up by a maximum of 20% in one year – the best way to
express that view is not generally through buying a call option, since
this might be expensive given that the option seller is also giving you
upside beyond the 20% increase.
Instead, the right product to express the view would be a call spread.
This is where an investor buys an at-the-money call option and sells
an out-of-the-money call option at 120, he explained. The option
premium that the investor pays is therefore much lower than would
have been paid on a call option, enabling the investor to express their
view in a more effective way.
If after one year the underlying is up 15%, the investor in a call spread
gets paid out 15%, said Mansuri, with anything beyond a 20% upside
retained by the option seller.
According to Mansuri, there are various key factors which affect option
pricing. First is the movement of the underlying stock price. So if
investors are buying a call option and the underlying stock price goes
up, the option gets more in-the-money, and vice versa for put options,
he explained.
Secondly, he said, the strike price is an important factor in determining
the option pricing. If the underlying is priced at 100 and investors are
buying at-the-money, it is likely to be more expensive than if they were
buying it out-of-the-money at 90.
Thirdly, time to maturity is an important factor affecting option pricing.
For example, said Mansuri, three-year options are more expensive
than one-year options as investors have more chance of making more
money as an option-buyer with a longer maturity product.
Fourthly, volatility is a key parameter in option pricing. The more
volatile the option the higher the chances it will go up, he explained.
Fifthly, the risk-free rate plays a role in option pricing, he said. So
if interest rates are higher, the forward is likely to be higher, so call
options will be more expensive.
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