May 23rd 2009, 02:17 system announcement
by Bogart Beck

SL Investment, Options & Pricing - 05/21/2009 - Bo Beck

SL Investment, Options & Pricing
May 21, 2009
By Bogart Beck

INTRODUCTION:

There's been a great deal of postulating recently across all of the SL Financial Forums about the "needs" of our community. Everything from Rules redux to Exchange regulation, education, enforecement and recourse against wayward CEO's.

One of the most popular topics has been the healthy exchange of ideas surrounding support of Derivatives Contracts (ie; PUT and CALL Options) in the marketplace. On the face of it, perhaps some sort of derivative-based hedge mechanism is indeed long overdue within our ecosystem, however, given the lack of a regulatory framework and effective tools for enforcement, what remains unanswered is the appropriate controls to support such products. My hope is that this article will help stimulate dialogue that might move the debate from "why not" to "what" and "how".

Before we get too far ahead of ourselves a baseline for discussion is necessary. At some level it would appear that a few parties within our community have lost sight of why the SL Capital Markets actually exist and what our real purpose is within the community. As most of our participants are aware, there are some foundational differences of opinion across the most popular SL Stock Exchanges that extend beyond just feature and marketing differentation. The debate regarding "RW Opportunity" versus "simulation" is a philosophical and legal argument that extends beyond our reach in this article, however, fundamentally any endeavor undertaken within the SL Capital Markets in this writers opinion MUST BE principally ABOUT Second Life(tm), its eco-system and our collective opportunities as participants within that eco-system to add-value to either its technical capabilities or the experience of patrons directly within the environment. For the life of me, I can not comprehend what purpose we serve as a community beyond that context; the SL Capital Market was, is and must always remain focused on the pricipal value-proposition of Second Life(tm) itself AND NOTHING MORE.

SL INVESTMENT:

Arguably, SL is an expensive endeavor for most entrepreneurial particpants. From a cost-of-entry standpoint, credible participation requires outlay of at least US $200-$300 per month for "ownership" (let's not argue that point today) of a SIM, plus the ability to invest at least 80-100 hours per month directly within the environment. Realistically that "cost" is beyond the reach of many without cooperative financial assistance. In my experience, some of the the best SL ideas have come from folks who simply lack the resources to fund development of their SL product or service concepts. Historically, freinds and family, Angel Investors and/or philanthropic entities have come alongside those folk and helped fulfill the capital needs of a community. While it's certainly part of the overall equation, a financial Return-on-Investment, if any, was typically secondary to fulfilling the greater good of the community.

The emergence of the SL Capital Markets as a somewhat ALTRUISTIC OUTREACH was a natural extension of the SL community. Somewhere along the way in the go-go hype of the last few years we seem to have lost sight of such purpose, and, just as in RL, a small but extremely vocal percentage of our population who's sole motivation is pure and simple GREED have undermined the benevolence of our community. Regardless, there are MANY OF US who still believe - if you're one of those, we welcome you with open arms and hope to help find ways to improve our community and experience, and perhaps even mitigate some of the risks inherent in funding the ideas of the underpriviledged in our community. You MAY even earn a small return on such investment - the real reward, however, remains in the sense of satisfaction that cooperative participation begets. If, however, you're one of those folk who are here principally to MAKE MONEY, please, go play on FOREX, CBOE, NASDAQ or elsewhere where the risk-reward proposition is princiapally about MONEY, and appropriate regulatory and prosecutorial mechanisms are in place to help ferret out the CRIMINAL activity such greed often attracts.

OPTIONS:

In the RW, 4 out of 5 companies FAIL within the first few years of operation, either as a result of mismanagement or changes in market conditions. In Second Life(tm) I'd argue that the failure rate is probably 9 out of 10 if not higher.

In that context, for those of us that are still willing to invest in SL companies (for whatever reason notwithstanding the cautionary statements above), there is indeed a desire to mitigate bona fide risk or "HEDGE" our bets so to speak.

One available mechanism to help accomplish that is an Investment vehicle called "OPTION CONTRACTS". So... WHAT are they and HOW do they work?

Let's start with the basics. Whereas a STOCK CERTIFICATE is evidence of an OWNERSHIP INTEREST in the underlying ASSETS and INCOME STREAM of a COMPANY, Option Contracts are something else entirely.

By definition OPTIONS are DERIVATIVES - they derive their VALUE from an underlying "SOMETHING ELSE". Therefore it is critically important that a potential investor understands EXACTLY what that "something else" is.

That doesn't mean that derivatives are inherently bad. Options are just tools, and they're only as good as the people using them. Shrewd use by well-educated investors can indeed mitigate risk and can improve an investors overall return on capital invested. Conversely however, by their very nature, Option Contracts can significantly AMPLIFY LOSSES. Reckless, ill-informed use of options can irrepairably damage your portfolio. To use options well, an investor MUST have a thorough understanding of the intrinsic value of the underlying forementioned "something else". As such, given the lack of transparency and reporting accuracy in our markets I personally believe that MOST INVESTORS should NOT consider Options as a significant portion of their SL Investment portfolio.

Nonetheless, it is painfully apparent that OPTION CONTRACTS are now emerging as an "investment opportunity" on a few of the SL-based Stock Exchanges. So, let's endeavor here to better understand them and how to properly use them. In the context of SL, the OPTION CONTRACTS will purportedly derive their value from an SL business whose "real worth" can be estimated as a reliable foundation for the issuance of such contracts. Does anyone yet see the real paradox here?

Generally, Option Contracts represent the RIGHT for one party to COMPEL (the OBLIGATION for the COUNTER-PARTY) some ACTION by a predetermined date. What's COMPELLED then is usually the buying or selling of shares of the underlying stock. Within that realm there are primarily two different types of Option Contracts - PUTS and CALLS. For each contract there are TWO SIDES to every Option Transaction - a BUYER and the UNDERWRITER (or SELLER). Each side of the contract has its own risk/reward scenario - The BUYER of the Option is commonly referred to as the LONG position, the UNDERWRITER (SELLER) is commonly referred to as the SHORT position. It is this "SHORT" Position that allows one to "HEDGE" risk.

What is currently being proposed and touted for SL Markets are called TRADEABLE OPTIONS which essentially are PRIVATE CONTRACTS between the two parties (Buyer and seller). In RW transactions the companies whose securities represent the underlying "something else" are NOT involved in the transactions. Cash flows and settlement between the various parties are typically underwritten and ADMINISTERED by a market maker or another middleman who has NO FIDUCIARY RELATIONSHIP to the transaction other than perhaps earning a nominal commission for facilitating the transaction or PERHAPS by offering to BUY AND SELL on BOTH SIDES of a transaction in the hopes of making a small profit on the BID/ASK spread prices.

CALL OPTIONS:

A CALL OPTION is the RIGHT to BUY an underlying stock at a PREDETERMINED PRICE (the strike price) on or before a PREDETERMINED DATE (the expiration). The BUYER of a CALL has the RIGHT (but NO OBLIGATION) to buy the shares at the strike price until expiration. The UNDERWRITER (SELLER) is the transactional COUNTER-PARTY and is OBLIGED TO DELIVER THE SHARES (SELL the stock at the strike price) if the Buyer elects to EXERCISE the Option up to the expiration date.

Fundamentally, a CALL OPTION BUYER seeks to make a profit when the price of the underlying shares RISES. Under normal market conditions the CALL PRICE should RISE as the SHARE PRICE RISES. Conversely, the CALL UNDERWRITER (SELLER) is making the OPPOSITE BET - hoping for the stock price to DECLINE or at least to RISE LESS THAN the dollar amount he initially received for selling the CALL OPTION.

PUT OPTIONS:

PUT OPTIONS conversely are the RIGHT to SELL an underlying stock at a predetermined strike price until a fixed expiration date. The PUT BUYER has the RIGHT (but NO OBLIGATION) to SELL shares at the strike price... the PUT UNDERWRITER (SELLER) is CONTRACTUALLY OBLIGATED to buy the shares at that predetermined strike price REGARDLESS OF THE CURRENT MARKET SHARE PRICE.

The PUT BUYER profits when the underlying stock price FALLS. A put increases in value as the underlying stock decreases in value. The UNDERWRITERS of PUT OPTIONS are hoping (betting) that the option will expire with the stock price ABOVE the strike price, or at least for the stock to decline an amount less than what they have been paid to sell the put.

EFFECT of MARKET CONDITIONS:

In a HEALTHY and FULLY-FUNCTIONAL marketplace, (that being a market that has relative EQUILIBRIUM and nominal PARITY between the BID and ASK volume of the underlying securities), PUT and CALL OPTION CONTRACTS *can* be viable and productive financial tools to help investors mitigate risk and/or "lock-in" stock profits. In such functional markets Option Contracts effectively act as a quasi-Insurance policy against unforseen NOMINAL changes in market conditions.

The marketplace is typically able to ABSORB any SHORT-TERM swings in sentiment, and both the OPTION CONTRACTS AND THEIR UNDERLYING STOCK are TRADEABLE within a marginally PREDICTABLE RANGE. It is specifically the PREDICTABILTY of the market that allows investors to LEVERAGE or PROTECT their investment portfolio.

Unfortunately, in an UNSTABLE MARKET, (that being a marketplace with irrational positive OR NEGATIVE sentiment), the OBLIGATION TO DELIVER undertaken by the UNDERWRITER of PUT or CALL OPTIONS has the POTENTIAL to completely WIPE-OUT (BANKRUPT) the Underwriter. Dare I declare that the SL Capital Markets at present are indeed an UNSTABLE marketplace with rampant negative sentiment and relatively slim prospects for a nearterm recovery. It matters NOT what has caused such sentiment - the fact remains that such conditions exist and as such the proposition of UNDERWRITING PUT and/or CALL OPTIONS remains a HIGHLY SPECULATIVE and EXCEPTIONALLY HIGH RISK endeavor for the Underwriter and the marketplace. In instances where the overall market experiences low liquidity, then, just as is witnessed in stock portfolios, the potential for wide Bid-Ask spreads on tradeable options surfaces. Illiquid Option Contracts provide ZERO PROTECTION!

Under such adverse market conditions the ability of the UNDERWRITER (and/or the secondary Market Maker) to PROPERLY PRICE an OPTION CONTRACT (PUT or CALL) is PARAMOUNT, particularly if Risk mitigation (ie; HEDGING) is the principal objective. It is in this area that I believe the current proponents of SL Options have either ENTIRELY MISSED THE BOAT *or* are so brazenly predatory as to hope to fleece unsuspecting market participants. It is my hope that the former is the case here. As I mentioned briefly in my previous article, UNDER NO CIRCUMSTANCE is it APPROPRIATE for the OFFICERS of an underlying security to also be the UNDERWRITER of OPTION CONTRACTS against such same security. It is WHOLLY UNETHICAL and is RIPE FOR ABUSE even in instances where appropriate regulatory oversight is available. At present, NO such oversight, nor any other reasonably reliable control mechanisms are in place in the SL Markets to police such abuses. Nonetheless, let's move on to the mechanics so that we can begin to establish a baseline for discussion of policies and practices that MAY be effective for the marketing of OPTION CONTRACTS within the SL Capital Marketplace.

OPTION MECHANICS:

In the context of the SL Capital Markets, the OPTION CONTRACTS curently being touted are in reality a form of Insurance against losses. Such Insurance has a COST -(NO FREE LUNCH)- such cost directly LIMITS your PROFIT POTENTIAL. If you're going to employ option strategies as part of your portfolio, you need to know how to understand options pricing. The first thing to understand is that Options are sold in contracts for (100) shares. Let's break that down a bit...

Let's assume that on January first you want to purchase a $100 3-Month CALL OPTION for XYZ Corporation. This means that you are purchasing the Opton to BUY 100 Shares of XYZ for $100 PER SHARE on or before March thirty-first. For that PRIVILEGE the Underwriter of the Call Option will extract a Premium of SOME DOLLAR AMOUNT that you PAY TO THE UNDERWRITER - that's your COST of the option (Note: this Cost DOES NOT INCLUDE THE COST OF THE SHARES THEMSELVES). Such COST will determine whether your OPTION CONTRACT finishes "IN THE MONEY" or "OUT OF THE MONEY" at Expiration and Settlement. Hold on to that "In / Out of the Money" phrase for a moment while we explore some of the other required mechanics.

You may occasionally hear the terms "European" or "American" style options. In a nutshell these terms simply denote a subtle difference in the stipulations attached to the options. A European option is one that can ONLY be exercised AT EEXPIRATION and NOT BEFORE. An American option is one that can be exercised AT ANY TIME right up to the moment of expiration. Generally, Exchange-Traded options that you'll likely find quoted in SL are American in nature, although you'll find that early exercise of such an option usually doesn't really make much sense. We'll cover WHY in a future Article where I'll discuss various strategies for effectively employing Options in your SL Capital Investment Portfolio.

In RW markets, the mechanics of matching an exercising option holder with an assigned option underwriter is handled behind the scenes by an options clearinghouse. Just like a Stock Exchange the clearinghouse performs non-fiduciary intermediation between counter-parties FOR A FEE - like a commission paid in a Stock Transaction. Specific to SL Markets, I will assume for the moment that most participants would consider the Stock Exchange itself to be an appropriate intermediary. It remains unclear to this writer if that relationship and expectation is fundamental to the assumptions being made by the Options proponents in our community. It would appear so, and while from a technical standpoint it seems to make good sense, my questions to the community would be as follows; Is such relationship appropriate? Would a THIRD-PARTY Market-Maker/Clearinghouse be a BETTER CHOICE? Would such third-party afford any better protection? WHO?

OPTION PRICING:

In the above example we discussed purchasing an $100 3-Month CALL OPTION for XYZ Corporation. In an efficient market, and assuming you've been correct in your assumptions regarding market sentiment and the general direction of the underlying security (XYZ Corp Stock), then the price of the shares will rise and will by extension take the value of the options options with it. But which options should you buy? What strike price? What expiration date? How will the option price behave as the stock price rises? What if the stock price falls? What happens as we approach the expiration date? This is where the SCIENCE and MATH of PRICING OPTIONS comes in. Ironically, it is this fundamental exercise that the current SL Options proponents tout as an unecessary complexity. They could NOT be farther from the truth. As I've stated previously, I hope such position is strictly the result of blissful ignorance versus more dubious intent.

Notwithstanding consideration of dividend-paying stocks which adds some MARGINAL complexity to pricing models which I'll discuss in a future article, in RW practice, (and I believe also appropriate and necessary for SL implementation), the PRICE of an OPTION is determined by the SUM OF TWO COMPONENTS: to wit INTRINSIC VALUE (IV) and TIME VALUE (TV). Thus OPTION VALUE = (IV) + (TV) .

(IV) is the difference between the stock price and the option's strike price. (IV) is calculated based on how the underlying stock price moves in relation to the option strike price: (IV) cannot be less than zero, since an option holder would not likely exercise a CALL with a STRIKE PRICE HIGHER than the price of the same stock trading on the open market.

(TV) is simply the premium that people are willing to pay for the potential upside of the stock until expiration. In a properly functioning market the (TV) of an Option will continually contract (get smaller) until expiration (where the TV = ZERO). Thus, at expiration the value of the option is simply (IV). Prior to expiration (TV) is ALWAYS POSITIVE (although it may be very small).

There are a few axioms to consider in PRICING OPTIONS, as follows;

1) Any time the strike price of an option is greater than or equal to the current stock price, IV is zero. In such cases, the option value is solely attributable to TV.

2) The less time remaining until expiration, the lower the TV. More time imparts greater value.

3) For options with a common expiration date, TV is maximized when the strike price and the stock price are equal. As the stock price moves in either direction, TV falls.

When discussing OPTION PRICING, you may often hear phrases like "in-the-money" or "out-of-the-money". This is just a fancy way of denoting whether an option has intrinsic value or not. If IV is positive, the option is said to be in-the- money. If IV is zero, it's termed out-of-the-money.

It should be clear that PRICING OPTIONS can not be an arbitrary function of the Underwriter but rather REQUIRES significant and diligent discipline - perhaps more than the SL Capital Markets can bare at this time. I'm very interested to get the perspective of readers OTHER THAN the current vocal proponents. If we're to move forward AS A COMMUNITY then the OPINIONS and CONCERNS of the quiet majority must be heard along with the pontifications of the vocal minority. If for any reason you the reader of this article do not feel comfortable sharing your thoughts in a public forum please feel free to contact privately via GMail - bogart.beck@gmail.com - I will assure confidentiality of your comments.