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Tuesday, March 1, 2011

What is an options spread?

An options spread is a technique used in stock options trading that makes use of two financial instruments known as 'options' orders so as to hedge risk and increase probability of profit by making use of different price movements by writing, selling, and/or buying options. An options spread can be used with any underlying market that allows trading via options.

The name option spread is no coincidence as the option is literally an option to use a financial instrument for a price. A spread represents two price points such as in a bid/ask spread, only in options, the spread is between two prices. When the words 'option' and 'spread' are brought together, so are the meanings of each word i.e. two options that represent a trading technique that involves financial contracts.

How an option spread works

Options are a derivative financial instrument meaning their value is derived from an underlying product. For example, with stock options, shares of a company are packaged into groups of 100 and bought and sold for a contract price or premium. The options can be either in the money, at the money or out of the money. This means the price of the underlying financial instrument can be either profitable, not profitable or even when exercised or used.

This contract, if bought, allows buyer to 'exercise' the options at a certain price before a specific date. If sold, the buyer of the option pays a premium to the seller and the seller pays the buyer if the option is exercised 'in the money' or beyond the 'strike' price i.e. the price after which the option becomes profitable. Some of the key elements of an options spread are listed below:

• Order type: ex: Limit order, market order, stop loss
• Risk: Potential to lose money via the spread
• Market: ex. Bull, bear, secular, cyclical
• Strategy: Option spread(s) used
• Broker: Trade facilitator
• Product: Stocks, commodities, currency

Types of option spreads

The type of option spread used reflects the strategy of the spread. For example, a calendar spread makes use of two different expiration dates for the same type of option. This type of spread may be used when the buyer or seller is convinced of a price movement but not the time when the price movement will occur. A number of different spread types exist, some of which are listed below:

• Bull Call Spread: Hedges cost of bullish options
• Bull Put Spread: Premium benefit if stock remains above strike price
• Bear Call Spread: Benefits flat price movement
• Bear Put Spread: Inverse of Bull Call Spread
• Calendar Spread: Makes use of different option expirations
• Backspread: Lowers risk for up and down price movements

Each of the above mentioned spreads makes use of different option types, techniques and predicted price movements. The variable element is the price movement which is it not guaranteed, and the details of each spread involve several variables and concepts, only a few of which are mentioned herein. In other words, when researching and making use of option spreads, it can be a good idea to pay close attention to 1) how the spread works, 2) when it is profitable, 3) the likelihood of it succeeding and 4) the monetary risk involved.

An options spread is trading mechanism that makes use of two financial instruments known as options. These are comprised of products from which the options' price is derived. Different types of options spreads are used to make use of 1) different price movement directions, 2) time of price movement, 3) extent of price movement and 4) combination of options used.

Options spreads are bought and sold using brokers and trade through markets such as the Chicago Board Options Exchange (CBOE). Options spreads are regulated by the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC). These regulatory bodies are further assisted by the participation of individual options exchanges in collaborative surveillance of their business through the Options Regulatory Surveillance Authority (ORSA)

Source: http://www.optionseducation.org/ (Options Industry Council)

The benefits of credit derivatives

Credit derivatives are exactly what the name implies i.e. derived from credit. In other words the financial instruments such as collateralized bonds are created from a credit instrument such as commercial credit or commercial loans. To illustrate, ABC company takes out a loan for project development from XYZ bank. XYZ bank has several such loan agreements with several companies. XYZ then decides it needs more capital to make more loans so it creates additional bank products such as bonds, that are collateralized by the commercial loans to ABC and other companies. These bonds are an example of credit derivatives since their value is based on the commercial loans.

Types of credit derivatives

Several types of credit derivatives exist, each with it's own purpose, core product, and rules of exchange. The reason derivatives have become more refined over time is because they tend to improve the efficiency of the originators business operations which in turn provides incentive for their creation. A few examples of derivatives are given below:

• Commodities derivatives: Financial instruments that's value is based on commodity value
• Corporate Bonds: Ex-Bundled loans in the form of an actively traded bond
• Credit Derivative Swaps: Ex- Exchanging of derivatives for insurance and/or another derivative.
• Credit Derivative Futures: Obligations to purchase credit derivatives at a future date with optional physical delivery.
• Credit Derivative Forwards: Similar to futures with less regulation and physical delivery

Mutual Funds Review: Russell 200 Index funds

Russell 2000 index funds are mutual funds and exchange traded funds (ETFs)based on the Russell 2000 index (^RUT). The Russell 2000 index is an equity weighted price metric for small capitalization companies also known as small caps. The Russell 2000 is considered an important index for measuring the performance of smaller companies across various industries and has several key features.

• Measures performance of companies with less than $1 billion in equity
• Consists of 2000 U.S. Small Capitalization companies
• Diversified across a number of industrial and service sectors
• Weighted for capitalization

Funds that attempt to correlate either directly or inversely with the index are trying to provide investors with a basket of small cap businesses similar in size and performance to those companies within the Russell 2000 index, or in the case of inverse funds, financial instruments believed to perform contrary to that of the businesses within the Russell 2000. Some Russell 2000 Index funds are listed below.

The difference between marginal and weighted average cost of capital

As the names imply, both weighted average cost of capital (WACC) and marginal cost of capital measure cost of capital. Capital is any money used to finance a business and/or its operations and can include a number of sources and methods. These sources may include traditional debt or equity financing or owner financing. Other forms of financing include grants, gains on investment capital, retained earnings, accrual financing contracts and forward payment agreements on capital.

Marginal cost of capital

Different types of capital are used in different amounts and for different costs. It is the costs of capital that is marginal and may involve or include a basic interest rate cost structure. For example, if Company A acquires a loan for $100K at an interest rate of 7% for one year, compounded annually, that capital will cost $7K. 

A simple average cost of capital may not accurately represent the true cost of capital for a company. For example, if Company A is financed by$100K of debt at 7%, $50K of equity at 12% and  $75K of owner financing at 0%, the average cost of capital would be 7% + 12% + 0% divided by 3=19%/3=6.33%. However this cost is not accurate because it does not take into account the different amounts of money at the different rates. In order to amend this discrepancy in calculation, the weighted average cost of capital is used.

Weighted average cost of capital

Weighted average cost of capital multiplies the amount of capital by the percent rate of cost for that capital as a proportional percentage of total capital and then averages 2 or more costs that are calculated in the same way. This can be further understood by dividing the previous sentence into two concepts: average amount of total capital and percentage cost of capital type. Using the above example concept one is illustrated below:

Concept 1: Average amount of total capital

If 3 types of capital are used; one at 44.44% of total capital, two at 22.22% of capital, and 3 at 33.33% of total capital the three added together add up to 99.99% of total capital. These 3 percentages are the proportions by which each rate of capital cost must be multiplied by in order to obtain the weighted average cost of capital.

Concept 2: Percentage cost of capital

The percentage cost of capital takes the marginal cost of capital and multiplies that by the proportional cost of capital. To continue illustrating with the above example, Company A uses $7K at 7% of debt at 44.44% of total capital that equals a proportional rate of 3.11%. Using the same reasoning for the $50K of equity at 12% and $75K of owner financing at 0%, WACC becomes 3.11% + 2.66% + 0%=5.77%/3=1.9233%. So the weighted average cost of capital is 1.9233% and is a more accurate representation of Company A's cost. The video below further illustrates the cost of capital calculation.

Marginal cost of capital and weighted average cost of capital a cost values that help a company manage its capital budgeting and asset management operations. Without knowing cost of capital, a company is less able to determine what rate of return projects and investments are required in order to break even, or surpass initial cost to acquire a profit margin. Marginal Cost of Capital may involve less calculation than WACC, however marginal cost may be calculated by incorporating tax rates, overhead, insurance or any other cost associated with acquiring the particular capital.

Marginal cost of capital can be included in the weighted average cost of capital calculation because each type of capital when weighted itself has marginal cost. Thus, marginal cost of capital and weighted average cost of capital are not necessarily mutually exclusive. Moreover, weighted average cost of capital generally cannot be a component of marginal cost of capital whereas the inverse is true for marginal cost of capital. Marginal cost of capital and WACC are important cost variables used in finance, accounting, project management, strategic management in addition to non-corporate analysis of the company such as in auditing, investment analysis, tax regulation and external financing.