Explanation of Timer Call Options

A timer call option is a rare and infrequently used model in which volatility is fixed instead of implied in an options contract. Typically, the implied volatility of a security is used to generate the current price of the option. It is hard to measure volatility, however, and this can often result in added expenses and risks in an options contract. With a timer call option, the volatility on a security is fixed, but the maturity rate is not fixed. This can reduce some risk and expense.

"Exotic Option"

It is worth noting that timer call options are "exotic," meaning they are not often used. Traditional options methods are more common and far more popular. They use implied volatility to set a current price, and the maturity is fixed. If you are familiar with traditional options contracts, you will need to understand the unique features of a timer call option prior to purchasing the contract. The function is very different because the volatility is fixed and not subject to changes due to realized volatility versus implied volatility. Timer call options are relatively new products, but popularity is expected to grow. They are currently popular among institutional investors such as hedge funds and private equity groups, which often set the standards that will be used by common investors in the future.

Timer Call Option Example

The investor in a timer call option sets an estimated maturity based on an estimated volatility. If the volatility estimate for a given period of time is correct, the option would mature at the estimated maturity date. If the volatility is lower than expected, the timer call option would expire later than the specified maturity period. Similarly, if the volatility level is higher than expected, the timer call option could mature early.  

Benefits of a Timer Call Option

The main benefit of the timer call option is eliminating risk premium. "Risk premium" is a term used to describe the difference between the implied volatility used to set an option's price and the realized volatility of a security over time. Rarely do these two converge. Instead, the implied volatility is almost always higher. The result is that the purchaser overpays for the options contract. This premium cannot be recovered even if the option is successful in the long run.

Risks of a Timer Call Option

All options are inherently riskier than straight security prices. This risk occurs because the investor is not actually purchasing an asset at the time he or she purchases an option. Instead, the investor is purchasing only the chance to buy or sell a security if certain conditions are met. With a timer call option, even though the risk premium is reduced, the risk of the purchase is not reduced. This is particularly true because the investor is essentially betting on the volatility of a security, which is one of the most challenging features to predict. As long as an investor understands this inherent risk, however, purchasing a timer call option is no riskier than purchasing any other option contract.

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