9.28.2007

VentureBeat » Fluid Innovation: The market for valuing intellectual property

VentureBeat » Fluid Innovation: The market for valuing intellectual property: " Groups of people can more accurately decide the worth of something than individuals can, at least if you believe in free markets.

Fluid Innovation wants to use this concept to create an online marketplace where companies can license large, unused stashes of original technology to other companies who see ways to bring it to market. Called Virtual Ventures, it will launch at DEMO this week.

The Austin, Texas company lets sellers — Fortune 1000 companies, for now — provide brief, business-focused descriptions about whatever intellectual property they may have, patented or not. Buyers, for now smaller software vendors and IT types, can buy “shares” in the seller’s technology they find most promising, based on an allotted number of shares each buyer is given each week. In other words, Fluid is creating an auction to try to determine the potential value of unexploited technology.

It is similar other marketplaces for patents, such as the LegalForce, Yet2.com (see coverage).

At Fluid Innovation, a seller can use this market to get a better idea of what their technology is worth, something that is often not clear if it was originally created to fill an internal need.

In one of example of how Fluid can work, Lockheed Martin Aeronautics’ legal team decided to commercialize software the company built to transmit technical data about F-16 fighter jets between maintenance crews. The team worked with Fluid to license the technology to a company called Jouve Aviation Solutions, which wants to provide the same service for other aircraft, as well.

In the corporate world, the idea of predictions markets is that employees can buy imaginary shares of proposed strategies, projects and other important decisions they favor — the smartest employees will favor the best ideas, influencing subsequent management decisions.

Internal stock markets of various sorts have been introduced at companies such as Microsoft, Intel and Hewlett-Packard.

Fluid Innovation is currently self-financed.

more here:

LegalForce, an online marketplace where patents can be bought, sold or licensed, has launched.

It is significant because it is a way for investors, entrepreneurs and investors to find ideas in an open, friendly way.

Its search engine lets you find patents, and contact information for all patent attorneys in the US, and some attorneys internationally. Eventually it will let you download all U.S. patents and find profiles of inventors, owners and attorneys associated with particular patents.

Jim Moore, a fellow at Harvard’s Berkman Center for Internet & Society, writes a glowing piece about the idea.

The site is still early, and buggy. We tried hitting the “bid” button on several listings this morning, and nothing happened (the company says it will be fixed shortly). When it works, you’ll get a detailed form that you fill out, and you’ll get matched with the seller. In some cases, sellers don’t set a price, but request negotiations.

As for competitors, Patent Cafe and Yet2.com have patent listings, but they offer consulting services or feature patents mainly for their clients, and so aren’t an arms-length marketplace like LegalForce. There’s also Ocean Tomo, which is a merchant bank that helps place values on patents to help facilitate buying and selling. The bank has hosted live auctions of patents, and also have a Dean’s List feature on its site — a sort of high-end marketplace for patents, based on Yet2.com’s platform. However, you have to pay for a listing. At LegalForce, listings are free.

Elsewhere, you have Google Patent Search, which is pretty useful — but it doesn’t offer a way to bid, and doesn’t have related attorneys and inventors hyperlinked in a social network. LegalForce, by contrast, builds links for such cross-referencing, in an attempt to be a place where interested players communicate.

The $250,000 seed-funded Palo Alto start-up is in the process of raising a$2 million first round.

Eventually, it plans to charge a transaction fee to cover its costs. It also wants to run advertising.

Below is a partial screenshot of a search result for a “Vehicle Location System” patent at LegalForce (not shown in our image is the extensive information that comes lower on the result page). Here is Google’s search result for the same listing. We couldn’t find it in Patent Cafe’s search or Yet2.com.

"

9.27.2007

The IN VIVO Blog: PSA Day 2: Buying into Biologics

The IN VIVO Blog: PSA Day 2: Buying into Biologics: "Building biologics expertise and capabilities piecemeal, says Mott, will be a long, slow and high-risk proposition, thanks in part to the dearth of biologics industry talent in key areas like regulatory affairs."

9.26.2007

Business development - Wikipedia, the free encyclopedia

Business development - Wikipedia, the free encyclopedia: "

Business development includes a number of techniques designed to grow an economic enterprise. Such techniques include, but are not limited to, assessments of marketing opportunities and target markets, intelligence gathering on customers and competitors, generating leads for possible sales, followup sales activity, formal proposal writing and business model design. Business development involves evaluating a business and then realizing its full potential, using such tools as marketing, sales, information management and customer service. For a sound company able to withstand competitors, business development never stops but is an ongoing process.

Successful business development often requires a multi-disciplinary approach beyond just "a sale to a customer." A detailed strategy for growing the business in desirable ways is frequently necessary, which may involve financial, legal and advertising skills. Business development cannot be reduced to simple templates applicable to all or even most situations faced by real-world enterprises. Creativity in meeting new and unforeseen challenges is necessary to keep an enterprise on a path of sustainable growth.

Small to medium-sized companies often do not establish procedures for business development, instead relying on their existing contacts. Other times they assume that because they know people in high places that their business development problems are solved and that somehow new business will come to them. The ramifications of such thinking can be significant in the event they are unable to leverage those relationships, which very often are personal or weak. Then they will have no new business in the pipeline.

The pipeline refers to flow of potential clients whom the company is in the process of developing. Each potential client in the pipeline is given a percent chance of success with projected sales volumes attached. The weighted average of all the potential clients in the pipeline can be used for staffing to manage the new business when it comes in.

For larger and more well-established companies, especially in technology-related industries, business development often refers to creating and managing strategic relationships and alliances with other, third party companies. In these instances the companies will leverage one anothers' expertise, technologies or other intellectual property to expand their products, services, functionality and/or market reach without having to invest in building or acquiring these with internal resources. Revenues are typically shared in some sort of royalty arrangement. For example, a company with a successful technology will partner with a company that has an existing customer base and sales force, and together they will penetrate that market, sharing the proceeds.

The set of efforts for identifying, researching, analyzing and bringing to market new businesses and new products, business development focuses on implementation of the strategic business plan through equity financing, acquisition/divestiture of technologies, products, and companies, plus the establishment of strategic partnerships where appropriate.

"

www.bbj.hu :: European biotech investments lagging behind US - study

www.bbj.hu :: European biotech investments lagging behind US - study: "
European biotechnology companies are being outpaced by their US competitors in research investments and in the scale of their operations, according to a new study from the European Union.

The figures, published by the EU’s statistical service, suggested that the 57 highest-spending EU companies in terms of biotechnology research and development spent, on average, €21 million ($30 million) in 2005. Of those companies, 28 are situated in the UK, with seven in Sweden, and six in Germany. In terms of European investments in R&D, the UK also leads, accounting for 44% of the total, followed by Denmark with 17% and Sweden with 12%. But while the average expenditure in Europe in 2005 was$160 million per company, US companies spent close to eight times more. “This gap in biotechnology R&D investment between the EU and US companies is unlikely to narrow in the near future because R&D funding in biotechnology is growing faster in the United States than in Europe,” the study said. The data assembled also showed that in 2003 Denmark was world leader in biotechnology patent applications to the European Patent Office, measured per capita. With more than 30 applications per million inhabitants, it produced nearly six times the EU average. It was followed by Iceland and Israel. Germany ranked first in Europe in absolute figures.

With 2,576 biotechnology patent applications submitted to the EPO, the EU ranked second worldwide in 2003, after the US (with 3,331) and ahead of Japan (with 1,035 applications). In Europe, Germany occupied first place with 901 applications, followed by the UK with 416 applications and by France with 370. In many countries, patent activity in biotechnology has been slowing down over recent years, the study said, with only Italy, Austria, Japan and some countries with very few patent applications showing accelerated activity.

In a ranking by biotechnology R&D intensity (a ratio of the expenditure in a sector compared with the value added in the same sector), Iceland was the clear leader in 2003, followed by Denmark and Switzerland. Across Europe, health is the main application field for biotechnology in most countries, often involving nearly half of all bio technologically active firms, the study claimed. In Germany two out of three biotech firms are working in the health care field - a situation broadly comparable to the US and China. European biotechnology-active firms are generally less active in agro-food applications than in other parts of the world (just 4% in Denmark and 6% in Switzerland), and the same is true for industrial-environmental applications of biotechnology, with the notable exceptions of Poland and Finland. (bioworld.com)"

9.25.2007

Speculator

Speculator: "A person who trades (i.e. derivatives, commodities, bonds, equities or currencies) with a higher-than-average risk, in return for a higher-than-average profit potential. Speculators take large risks, especially with respect to anticipating future price movements, or gambling, in the hopes of making quick, large gains. Investopedia Says... Speculators are typically sophisticated, high risk-taking investors with expertise in the market(s) to which they are trading and will usually use highly leveraged investments such as futures and options."

Speculators and Markets

Speculators and Markets: "

Speculators and Markets

Suppose that you receive an advertisement in the mail offering you a book that tells you how you can beat the stock market and become rich. If this book is offered to you for a mere $50, should you buy it? A little reflection should suggest that you be very, very suspicious. If there was a way to beat the market, the person who had the way should keep quiet and use it. Once the method becomes publicly known, its use will eliminate any source of profit. A financial market is an "efficient market" if its prices take into account all knowledge that people have about that market. (Notice that the use of the word "efficiency" in this context is not the same as the use of the word in most of microeconomics.) If there is knowledge that is not being used, unexploited profit opportunities exist, and in financial markets these opportunities should be quickly taken. If one knows that a stock or bond is undervalued and that it will rise in value, one will make a large amount of money by buying until it does rise. Because profit opportunities are quickly exploited once they become known, one cannot "beat" an efficient market unless one has special information that is unavailable to others. If the stock market is an efficient market, movements of stock prices from day to day will be random. Knowing the past movements of the stock does not help one predict what the future price will be. This idea contradicts the technique of picking stocks used by "chartists" or "technicians" who believe that past movements can reveal patterns. A variety of studies that have compared randomly picked portfolios of stocks with stocks chosen by various technical rules supports the idea that information about past movements of stock prices does not help predict the future. The idea of efficient markets suggests that one should not place a great deal of faith in any forecasts about interest rates or stock prices, because if the person making the forecast really does know what will happen, he could keep quiet and get rich. Speculators play a useful role in an efficient market where prices adjust very quickly to new information. They are coolly rational individuals looking at the fundamental values of items, buying when prices are too low and helping lift these prices, and selling when prices are too high and helping to lower these prices. As a result, prices correctly transmit information about values that people can then use to make decisions. An efficient market will not be the source of economic disturbances. It can, however, transmit disturbances, and this alone would be enough to interest economists. However, there are some who argue that financial markets are not efficient and do not always adjust to economic conditions. They argue that those trading in financial markets are not always calmly rational in the way that those who believe in efficient markets picture them. Rather traders can go on speculative binges, ignoring reality. An important reason people buy items in financial markets is in the hope of selling them at a profit. Thus trading in these markets involves not only an analysis of the fundamental value of an asset, but also an analysis of how other people will react. If people are confident that others will buy the item for more than they paid for it, then they will buy it even if it has little value to them. The idea described above has been called the "greater-fool" theory. It implies that although one may be a fool for buying an asset that is overpriced, one can profit if there are still greater fools who will pay even more for it. The idea is an example of the model of contingent behavior. In contingent behavior, people's actions are based on the way they expect others to act. To the extent that people act in this way and that "greater-fool" speculating influences prices in financial markets, financial markets can serve as a source of economic disturbances rather than as mere transmitters. There are many cases in which markets clearly were on speculative binges. One of the earliest and most famous was the Dutch tulip market of the 1630s. The tulip was introduced into Holland in the middle of the 16th century from Constantinople. It immediately became a status symbol among the very rich, and then as it became a bit less rare, among the middle classes. According to Charles Mackay, "Until the year 1634 the tulip annually increased in reputation, until it was deemed a proof of bad taste in any man of fortune to be without a collection of them."1 After 1630 the price of tulips reflected not only their stylishness, but also speculation. People began to gamble on price changes. As people began to join the speculation, trying to get in at low prices, prices took off and the market developed a life of its own. People bought tulips at ridiculous prices only because they thought other people would be willing to pay equally ridiculous prices. For example, a single bulb was exchanged for twelve acres of land. Another was sold for a carriage, two horses, and a substantial sum of cash. The "bulls"--those who expected rising prices--ruled the bulb market until 1636. The boom faded when enough Dutchmen began to wonder if tulip bulbs were really worth what they were being traded for, and decided to get out of the market while they were ahead. As this sentiment spread, the market peaked and began to fall. Speculative markets can crash almost instantly because once prices begin to fall, people realize that there is no fundamental reason for them to be so high. The prices of tulip bulbs fell until they reached a realistic value, which meant that a single bulb was almost worthless. Looking back at tulipmania, we have a tendency to think, "That is a funny episode, but of no importance. People are smarter today." Yet in 1982 a major speculative binge came to an end, leaving debts in the area of$90 billion. The binge took place in Kuwait in an unregulated over-the-counter market called the Souk al-Manakh. The market was limited to trading in only about 35 companies, most of which were small, and many of which did not even publish annual reports. Activity was clearly speculative, and as prices rose and banks began to refuse to lend money to finance deals, people began to use postdated checks. In effect, people promised to pay based on the belief that they could sell their securities for more than they had paid, and thus redeem the check. Under Kuwaiti law, a check is payable on demand regardless of the date. The collapse came in August of 1982 when someone demanded early payment on a check that could not be paid. With confidence in the system shaken, prices quickly collapsed.2 Also, greater-fool psychology seems to widespread in the run up of the prices of the dot-com stocks in the late 1990s.

Markets based on "greater-fool" psychology always collapse. Eventually the greatest fool is found, and once he is found, the process cannot continue. In many ways a speculative binge is like a chain letter. Everyone involved in a chain letter believes that he or she will get rich. But since all that is involved is a reshuffling of money, (in technical jargon, a chain letter is a zero-sum game), if someone does get rich, others must get poorer. Like speculative binges, chain letters die when the greatest fools have found and joined the chain.

Speculative binges can affect the production of an economy if they cause enough financial disruption. They will cause bankruptcies, reduce people's trust in others, and cause unemployment for the people who became speculators. However, few periods of inflation or recession can be linked to speculative binges, and, as a result, most economists do not believe that they, or the financial markets, are an important source of macroeconomic disturbance.

Some people argue that the Great Depression was a result of a speculative binge in the stock market in 1928 and 1929. Most economists dismiss this theory because prices in the stock market did not reach levels that were clearly outlandish. Some market watchers have even argued that stock prices were not overvalued at all in 1929 if the 1930s would have been a normal decade.

Even if one believes that stocks were overvalued in 1929, and that the stock market had gone on a speculative binge, it is hard, and perhaps impossible, to explain why the results of this particular binge were so much more severe than the aftereffects of other, equally large binges in the stock market. In particular, the very large drop in stock market prices on Monday, October 19, 1987 left few traces on production or consumption during the following year. Yet on that one day the value of common stocks, as measured by the Dow Jones Industrial Index, dropped by more than 22%. Clearly a speculative crash in financial markets is not enough, by itself, to trigger a recession.

The foreign exchange markets are an important group of financial markets.

"

Speculation - Wikipedia, the free encyclopedia

Speculation - Wikipedia, the free encyclopedia: "

Speculation, in the narrow sense of financial speculation, involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. Speculation or agiotage represents one of three market roles in Western financial markets, distinct from hedging, long- or short-term investing, and arbitrage.

Speculation areas

Convention, and especially satire, sometimes portray speculators comically as speculating in pork bellies (in which a real market and real speculators exist) and often "losing their shirts" or making a fortune on small market changes. Speculation exists in many such commodities, but, if measured by value, the most important markets deal in futures contracts and other derivatives involving leverage that can transform a small market movement into a huge gain or loss.

Type of speculators

Most non-professional traders lose money on speculation, while those who do make money tend to become professionals. Occasionally some dramatic event will occur, such as the effort of the Hunt brothers to corner the silver market or the currency speculations of George Soros or the speculative trading of Nick Leeson, which caused the collapse of Barings Bank.

By some definitions, most long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are not primarily motivated by eventually selling at a good profit. Some dedicated speculators are distinguished by shorter holding times, the use of leverage, by being willing to take short positions as well as long positions (in markets where the distinction can be reasonably made). A degree of speculation exists in a wide range of financial decisions, from the purchase of a house to a bet on a horse; this is what modern market economists call "ubiquitous speculation."

In Security Analysis, Benjamin Graham gave a definition of speculation in relation to investment: "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

The economic benefits of speculation

The service provided by speculators to a market is primarily that by risking their own capital in the hope of profit, they add liquidity to the market and make it easier for others to offset risk, including those who may be classified as hedgers and arbitrageurs.

If a certain market - for example, pork bellies - had no speculators, then only producers (pig farmers) and consumers (butchers, etc.) would participate in that market. With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell pork bellies will be forced to accept an illiquid market and market prices that have a large bid-ask spread or might even find it difficult to find a co-party to buy or sell to. A speculator (e.g. a pork dealer) may exploit the difference in the spread and, in competition with other speculators, reduce the spread, thus creating a more efficient market.

Another example of the value of speculators is the ability of a pig farmer to sell his pork on a futures exchange at a known price ahead of its production.

Some side effects

Auctions are a method of squeezing out speculators from a transaction, but they have their own perverse effects; see winner's curse. The winner's curse is however not very significant to markets with high liquidity for both buyers and sellers, as the auction for selling the product and the auction for buying the product occur simultaneously, and the two prices are separated only by a relatively small spread. This mechanism prevents the winner's curse phenomenon from causing mispricing to any degree greater than the spread.

Speculative purchasing can also create inflationary pressure, causing particular prices to increase above their "true value" (real value - adjusted for inflation) simply because the speculative purchasing artificially increases the demand. Speculative selling can also have the opposite effect, causing prices to artificially decrease below their "true value" in a similar fashion. In various situations, price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise. This creates a positive feedback loop in which prices rise dramatically above the underlying "value" or "worth" of the items. This is known as an economic bubble. Such a period of increasing speculative purchasing is typically followed by one of speculative selling in which the price falls significantly, in extreme cases this may lead to crashes. Overall, the participation of speculators in financial markets tends to be accompanied by significant increase in short-term market volatility. This is not necessarily a bad thing, as heightened level of volatility implies that the market will be able to correct perceived mispricings more rapidly and in a more drastic manner.

Etymology

The word "speculate" comes from the Latin word speculatus, which is the past participle of speculari , meaning to look ahead, to spy, and to examine. The word speculari derives from the name specula, from specere "to see", who was the Roman legionary that watch the legion's camp known as castrum. In this word we find the etymological significant of the contemporanean word, that implies the activity of looking at distant things, in the space and also in the time. From "specula" derive in late Latin the word "speculatio, speculationis", the activity of philosophical enquiring. The word is used now with this sense in philosophy, as the activity of theorizing without a solid factual base, as the modern financial speculator who take position in the market without a solid statistical base.

Books

• Sobel, Robert [1973] (2000). The Money Manias: The Eras of Great Speculation in America, 1770-1970. Beard Books. ISBN 1-58798-028-2.
• Gunther, Max (1992). The Zurich Axioms. Souvenir Press. ISBN 0-285-63095-4.
• Niederhoffer, Victor (2005). Practical Speculation. Wiley. ISBN 0-471-67774-4.

Wikiquote has a collection of quotations related to:
Look up speculation in Wiktionary, the free dictionary.
."

9.24.2007

Option (finance) - Wikipedia, the free encyclopedia

Option (finance) - Wikipedia, the free encyclopedia: "

Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security. For example, buying a call option provides the right to buy a specified amount of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract.[1]

The theoretical value of an option can be determined by a variety of techniques, including the use of sophisticated option valuation models. These models can also predict how the value of the option will change in the face of changing conditions. Hence, the risks associated with trading and owning options can be understood and managed with some degree of precision.

Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions, that have negotiated separate trading and clearing arrangements with each other. Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation.

Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Contract specifications

Every financial option is a contract between the two counterparties. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:[2]

• whether the option holder has the right to buy (a call option) or the right to sell (a put option)
• the amount and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock)
• the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise
• the expiration date, or expiry, which is the last date the option can be exercised
• the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount
• the terms by which the option is quoted in the market, usually a multiplier such as 100, to convert the quoted price into actual premium amount

Types of options

The primary types of financial options are:

• Exchange traded options (also called "listed options") is a class of exchange traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include:[3][4]
1. stock options,
2. commodity options,
3. bond options and other interest rate options
4. index (equity) options, and
5. options on futures contracts
• Over-the-counter, or OTC options are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include:
1. interest rate options
2. currency cross rate options, and
3. options on swaps or swaptions.

Option styles

Main article: Option style

Naming conventions are used to help identify properties common to many different types of options. These include:

• European option - an option that may only be exercised on expiration.
• American option - an option that may be exercised on any trading day on or before expiration.
• Bermudan option - an option that may be exercised only on specified dates on or before expiration.
• Barrier option - any option with the general characteristic that the underlying security's price must reach some trigger level before the exercise can occur.

Valuation models

The value of an option can be estimated using a variety of quantitative techniques, although most commonly through the use of option pricing models such as Black-Scholes and the binomial options pricing model.[5] In general, standard option valuation models depend on the following factors:

• The current market price of the underlying security,
• the strike price of the option, particularly in relation to the current market price of the underlier,
• the cost of holding a position in the underlying security, including interest and dividends,
• the time to expiration together with any restrictions on when exercise may occur, and
• an estimate of the future volatility of the underlying security's price over the life of the option.

More advanced models can require additional factors, such as an estimate of how volatility changes over time and for various underlying price levels, or the dynamics of stochastic interest rates.

The following are some of the principal valuation techniques used in practice to evaluate option contracts.

Black Scholes

Main article: Black Scholes

The Black-Scholes model was the first quantitative technique to comprehensively and accurately estimate the price for a variety of simple option contracts. By employing the technique of constructing a risk neutral portfolio that replicates the returns of holding an option, Fischer Black and Myron Scholes produced a closed-form solution for a European option's theoretical price.[6] At the same time, the model generates hedge parameters necessary for effective risk management of option holdings. While the ideas behind Black-Scholes were ground-breaking and eventually led to a Nobel Prize in Economics for Myron Scholes and Robert Merton, application of the model in actual options trading is clumsy because of the assumptions of continuous (or no) dividend payment, constant volatility, and a constant interest rate. Nevertheless, the Black-Scholes model is still widely used in academic work, and for many financial applications where the model's error is within margin of tolerance.[7]

Binomial option pricing model

Closely following the derivation of Black and Scholes, John Cox, Stephen Ross and Mark Rubinstein developed the original version of the binomial options pricing model.[8] [9] It models the dynamics of the option's theoretical value for discrete time intervals over the option's duration. The model starts with a binomial tree of discrete future possible underlying stock prices. By constructing a riskless portfolio of an option and stock (as in the Black-Scholes model) a simple formula can be used to find the option price at each node in the tree. This value can approximate the theoretical value produced by Black Scholes, to the desired degree of precision. However, the binomial model is considered more accurate than Black-Scholes because it is more flexible, e.g. discrete future dividend payments can be modeled correctly at the proper forward time steps, and American options can be modeled as well as European ones. Binomial models are widely used by professional option traders.

Heston model

Main article: Heston model

Since the market crash of 1987, it has been observed that market implied volatility for options of lower strike prices are typically higher than for higher strike prices, suggesting that volatility is stochastic, varying both for time and for the price level of the underlying security. Stochastic volatility models have been developed including one developed by SL Heston.[10] One principal advantage of the Heston model is that it can be solved in closed-form, while other stochastic volatility models require complex numerical models.[10]

Monte Carlo model

Main article: Monte Carlo model

For many classes of options, traditional valuation techniques are intractable due to the complexity of the instrument. In these cases, a Monte Carlo approach may often be useful. Rather than attempt to solve the differential equations of motion that describe the option's value in relation to the underlying security's price, a Monte Carlo model determines the value of the option for a set of randomly generated economic scenarios. The resulting sample set yields an expectation value for the option.

Risks

As with all securities, trading options entails the risk of the option's value changing over time. However, unlike traditional securities, the return from holding an option varies non-linearly with the value of the underlier and other factors. Therefore, the risks associated with holding options are more complicated to understand and predict.

In general, the change in the value of an option can be derived from Ito's lemma as:

$dC=\Delta dS + \Gamma \frac{dS^2}{2} + \kappa d\sigma + \theta dt \,$

where the greeks Δ, Γ, κ and θ are the standard hedge parameters calculated from an option valuation model, such as Black-Scholes, and dS, dσ and dt are unit changes in the underlier price, the underlier volatility and time, respectively.

Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameters and then estimating the expected change in the model inputs, dS, dσ and dt, provided the changes in these values are small. This technique can be used effectively to understand and manage the risks associated with standard options. For instance, by offsetting a holding in an option with the amount − Δ of shares in the underlier, a trader can form a delta neutral portfolio that is hedged from loss for small changes in the underlier price. The corresponding price sensitivity formula for this portfolio is:

$d\Pi=\Delta dS - \Delta dS + \Gamma \frac{dS^2}{2} + \kappa d\sigma + \theta dt = \Gamma \frac{dS^2}{2} + \kappa d\sigma + \theta dt\,$

Example

A call option expiring in 99 days on 100 shares of XYZ stock is struck at $50, with XYZ currently trading at$48. With future realized volatility over the life of the option estimated at 25%, the theoretical value of the option is $1.89. The hedge parameters Δ, Γ, κ, θ are (0.439, 0.0631, 9.6, and -0.022), respectively. Assume that on the following day, XYZ stock rises to$48.5 and volatility falls to 23.5%. We can calculate the estimated value of the call option by applying the hedge parmeters to the new model inputs as:

$dC = (0.5 \cdot 0.439) + (\frac{0.5^2}{2} \cdot 0.0631) - (0.015 \cdot 9.6) - 0.022 = 0.132$

Under this scenario, the value of the option increases by $0.132 to$2.022, realizing a profit of $13.20. Note that for a delta neutral portfolio, where by the trader had also sold 44 shares of XYZ stock as a hedge, the net loss under the same scenario would be ($8.75).

Pin risk

Main article: Pin risk

A special situation called pin risk can arise when the underlier closes at or very close to the option's strike value on the last day the option is traded prior to expiration. The option writer (seller) may not know with certainty whether or not the option will actually be exercised or be allowed to expire worthless. Therefore, the option writer may end up with a large, unwanted residual position in the underlier when the markets open on the next trading day after expiration, regardless of their best efforts to avoid such a residual.

The most common way to trade options is via standardized options contracts that are listed by various futures and options exchanges. [11] By publishing continuous, live markets for option prices, an exchange enables independent parties to engage in price discovery and execute transactions. As an intermediary to both sides of the transaction, the benefits the exchange provides to the transaction include:

• fulfillment of the contract is backed by the credit of the exchange, which typically has the highest rating (AAA),
• counterparties remain anonymous,
• enforcement of market regulation to ensure fairness and transparency, and
• maintenance of orderly markets, especially during fast trading conditions.

Over-the-counter options contracts are not traded on exchanges, but instead between two independent parties. Ordinarily, at least one of the counterparties is a well-capitalized institution. By avoiding an exchange, users of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In addition, OTC option transactions generally do not need to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must establish credit lines with each other, and conform to each others clearing and settlement procedures.

With few exceptions,[12] there are no secondary markets for employee stock options. These must either be exercised by the original grantee or allowed to expire worthless.

These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging.

Long Call

Payoffs and profits from a long call.

A trader who believes that a stock's price will increase might buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiration date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares.

Short Call

Payoffs and profits from a naked short call.

A trader who believes that a stock price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.

Long Put

Payoffs and profits from a long put.

A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiration date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless and only lose his premium paid.

Short Put

Payoffs and profits from a naked short put.

A trader who believes that a stock price will increase can buy the stock or instead sell a put. The trader selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the amount of the premium, the short will lose money, with the potential loss being up to the full value of the stock.

Option strategies

Main article: Option strategies

Combining any of the four basic kinds of option trades (possibly with different exercise prices and maturities) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.

Strategies are often used to engineer a particular risk profile to movements in the underlying security. For example, buying a butterfly spread (long one X1 call, short two X2 calls, and long one X3 call) allows a trader to profit if the stock price on the expiration date is near the middle exercise price, X2, and does not expose the trader to a large loss.

Selling a straddle (selling both a put and a call at the same exercise price) would give a trader a greater profit than a butterfly if the final stock price is near the exercise price, but might result in a large loss.

Historical uses of options

Contracts similar to options are believed to have been used since ancient times. In the real estate market, call options have long been used to assemble large parcels of land from separate owners, e.g. a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the right — but not the obligation — to dramatize a specific book or script. Lines of credit give the potential borrower the right — but not the obligation — to borrow within a specified time period.

Many choices, or embedded options, have traditionally been included in bond contracts. For example many bonds are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early.

Privileges were options sold over the counter in nineteenth century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was fixed at a rounded-off market price on the day or week that the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets.

References

1. ^ Brealey, Richard A. & Stewart Myers (2003), Principles of Corporate Finance (7th ed.), McGraw-Hill, Chapter 20
2. ^ . "Characteristics and Risks of Standardized Options" (PDF). Options Clearing Corporation. Retrieved on 2007-06-21.
3. ^ Trade CME Products. Chicago Mercantile Exchange. Retrieved on 2007-06-21.
4. ^ ISE Traded Products. International Securites Exchange. Retrieved on 2007-06-21.
5. ^ Reilly, Frank K. & Keith C. Brown (2003), Investment Analysis and Portfolio Management (7th ed.), Thomson Southwestern, Chapter 23
6. ^ Black, Fischer and Myron S. Scholes. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, 81 (3), 637-654 (1973).
7. ^ Hull, John C. (2005), Options, Futures and Other Derivatives (6th ed.), Prentice-Hall, ISBN 0131499084
8. ^ Cox JC, Ross SA and Rubinstein M. 1979. Options pricing: a simplified approach, Journal of Financial Economics, 7:229-263.[1]
9. ^ Cox, John C. & Mark Rubinstein (1985), Options Markets, Prentice-Hall, Chapter 5
10. ^ a b Jim Gatheral (2006). The Volatility Surface, A Practitioner's Guide. Wiley Finance. ISBN 978-0471792512.
11. ^ Harris, Larry (2003), Trading and Exchanges, Oxford University Press, pp.26-27
12. ^ Elinor Mills. "Google unveils unorthodox stock option auction", CNet, 2006-12-12. Retrieved on 2007-06-19.