John C. Hull


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John Hull is the Maple Financial Group Professor of Derivatives and Risk Management and Director of the Bonham Centre for Finance in the Joseph L. Rotman School of Management at the University of Toronto. He is an internationally recognized authority on financial engineering and has many publications in that area. Recently his research has focused on interest rate options, credit risk, and market risk. He was voted Financial Engineer of the Year in 1999 by the IAFE.

Books

Options, Futures and Other Derivatives , FT Prentice Hall, 1999

Fundamentals of Futures and Options Markets , FT Prentice Hall, 2001

Hull-White on Derivatives , Risk Publications, 1996

Option valuation and trading

  1. To make money trading options you must take a different view from most other market participants - and you must be right.

    An example illustrates the point here. Suppose you think there will soon be some news leading to a big change in a company's stock price (This could be the result of an attempted takeover or the outome of a major lawsuit). You might try a straddle trading strategy. This involves buying a call and a put with the same strike price and time to maturity. If the news is favourable to the company, you expect the call to provide a big payoff; if it is unfavourable to the company, you expect the put to provide a big payoff. The strategy works well if few other people have the same idea. But, if most other market participants also expect a big price change, the prices of calls and puts will be bid up and there will be no easy profits.

  2. Do not imply the volatility from the price of one option on a stock and use it to price another.

    This used to be recommended, but it is now recognized that the market does not use the same volatility to price all options. (This means that the market does not agree with the assumptions underlying Black-Scholes.) In equity markets the volatility used to price an option is a decreasing function of strike price. For example 28% might be used to price a low-strike-price option on the S&P 500 while 20% is used to price a high-strike-price option on this index.

  3. As a rough approximation , the price of an at-the-money option increases with the square root of its time to maturity.

    This rule is related to a more general result that states that our uncertainty about the future value of a market variable increases (at least approximately) as the square root of how far ahead we are looking. Our uncertainty about the value in four months is approximately twice (not four times) our uncertainty about the value in one month.

  4. When we use the risk-neutral valuation principle we are not valuing options on the assumption that investors are risk neutral.

    Risk neutral valuation is the most important principle in option pricing and is very widely used. It states that we get the right price for an option (or any other derivative) if we assume investors are risk neutral. The price is correct in situations where investors are risk averse as well as in situations where they are risk neutral.

  5. Never trade a product without fully understanding it and evaluating the risks.

    This might seem a somewhat obvious rule. In fact, many of the well-publicized derivatives disasters of financial and non-financial companies were caused by individuals who failed to follow the rule.

  6. When you speculate with options, you are taking a position not only on what will happen but when it will happen.

    Options have limited lives. How often does it happen that an investor buys a call option on a stock and finds that the stock price shoots up during the week after the end of the life of the option?

  7. Option pricing models such as Black-Scholes are nothing more than sophisticated interpolation tools.

    They should be used with caution by investors. Professional traders price options as follows . Each day they observe the prices of a number of actively traded options in the market. They use Black-Scholes to calculate implied volatilities for these options. They then interpolate between the implied volatilities to get a table showing the implied volatility as a function of strike price and time to maturity. This table is used to price other options during the day.

  8. When uncertainty increases in the market the volatilities of short-dated options increase by more than the volatilities of long-dated options.

    The volatility of an asset is what analysts refer to as mean reverting . It tends to be pulled back to its long run average (normal) level. When market uncertainty increases the volatility increases, but after that it tends to be pulled back to normal levels. The implied volatility of an option can be thought of as what investors expect the average level of the volatility to be over the life of the option. For a long-dated option, this is less than for a short-dated option in the situation considered .

  9. Keep your eyes open for valuable option add-ons.

    Options are sometimes added to other products by financial institutions. For example, a bank when offering a mortgage may quote a rate and say that it is good for two months. (If rates improve you get the improved rate.) British insurance companies have in the past offered annuities where the interest rate used to calculate the annual amount is guaranteed to be not less than a certain level. Often the option is considered a cost of doing business and not properly priced into the product.

  10. Never forget to factor transaction costs into your calculations when considering option trades.

    Transaction costs can be high for options. One type of transaction cost is the broker's commission. Another hidden transaction cost is the market maker's bid-offer spread. If the bid is $4.75 and the offer is $5.25, our best estimate of the market price is $5.00 and there is a $0.25 (= 5%) transaction cost every time you trade. Commissions are required when options are exercised. Sometimes, when transaction costs are taken into account, it is more favourable to sell an option than exercise it.

www.rotman.utoronto.ca

'Research has shown that companies in which the post of Chairman and Chief Executive were held by the same person had more than a 50% higher chance of going bust than other listed companies. Maxwell (who had his two sons as Joint Managing Directors) and Asil Nadir at Polly Peck are two classics, but there are plenty of others.'

”Alan Sugden



Global-Investor Book of Investing Rules(c) Invaluable Advice from 150 Master Investors
The Global-Investor Book of Investing Rules: Invaluable Advice from 150 Master Investors
ISBN: 0130094013
EAN: 2147483647
Year: 2005
Pages: 164

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