Options
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"An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date"
Option definition
Call options give the option to buy at certain price, so the buyer is betting on the price going up.
Put options give the option to sell at a certain price, so the buyer is betting on the price going down.
Introduction
Options are types of financial derivatives. A financial derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties and its value is determined by the price of the underlying asset.
Most options are created in a standard format and can be traded on public option exchanges. You may come across some options that are traded Over-The-Counter, also known as OTC, these option contracts will normally have non-standard elements and are not traded on an exchange.
The price at which the underlying asset may be exercised is called the strike price or exercise price. The process of triggering an option and thereby trading the underlying asset at the agreed price is known as exercising it. If the option is not exercised by the expiration date, it becomes void and worthless.
In return for assuming the obligation the writer of the option collects a payment, the premium, from the buyer. The writer of an option must make good on delivering (or receiving) the underlying asset or its cash equivalent, if the option is exercised.
Contract details
Options are contracts between two parties and the terms are detailed in an option term sheet. Options have multiple elements and can range from standard to very complicated. Below outlines some items you will see mentioned on an Option term sheet.
- whether the option holder has the right to buy or the right to sell
- the strike price, also known as the exercise price, which is the price at which the underlying transaction will be exercised
- the quantity and type of the underlying asset
- the premium due to be paid by the holder to the writer of the option
- the settlement terms e.g. must the actual asset be delivered or will it be the cash equivalent
Advantages:
- Option trading is quite flexible and allows investors to assume or create a position they predict will be profitable. It can allow investors to profit from both a rising and falling market.
- Hedging using options allows investors to manage and reduce potential risk.
- Trading options allows investors to leverage their positions.
- There can be reduced risk compared to other types of trading instruments. As risk is limited to the option premium, so the maximum loss is the price you paid to purchase it (known as premium).
Disadvantages:
- The cost of trading options can be higher on a percentage basis than trading the underlying stocks.
- The short selling of options is accompanied by unlimited risk.
- Options can so complex that they requires close observation and maintenance.
- Options will expire at a fixed point in time and lead to most expiring worthless.
Types of Options
As mentioned above there are two types of options, exchange-traded options and over-the-counter options (OTC). Here's a closer look at the two types: Exchange-traded options are a type of exchange-traded derivative. These are also referred to as listed options. Exchange-traded options have standard contracts. Trading is settled through a clearing house with trade fulfillment guaranteed by the Options Clearing Corporation (OCC). As each contract is standard it is possible to obtain accurate valuations via pricing models. Sub-types of Exchange-trade options include:
- index options
- stock options
- bond options
- interest rate options
- options on future contracts
Over-the-counter options are not listed on an exchange but traded between two private parties. Are sometimes referred to as 'dealer options'. Terms for an OTC are unlimited and can be tailored around investment needs of the parties involved. On most occasions one of the parties is usually a large institutions like a bank or brokerage house. Option types commonly traded over the counter include:
Option Styles
Below naming conventions are used to help identify properties common to many different styles of option along with their unique features:
- European option - can only be exercised on expiration
- American option - may be exercised on any trading day on or before expiry.
- Bermudan option - may be exercised only on specified dates on or before expiration.
- Barrier option - the underlying security's price must pass a certain level or "barrier" before it can be exercised.
- Exotic option - a broad category of options that may include complex financial structures.
- Vanilla option - any option that is not exotic.
Trading Overview
Options are typically traded in standard contracts on several futures and options exchanges. The Chicago Board Options Exchange (CBOE) is an example of an options exchange. Each standard option contract will have a ticker symbol. This allows for buying and selling of options on the exchanges and providing valuation and pricing details to vendors. Trading of Over-The-Counter (OTC) option contracts does not occur on the exchanges mentioned above. Typically at least one counterparties in an OTC trade is a well-capitalised institution e.g. brokerage/bank. OTC options allow investors to define specific terms which may not be obtainable on standard option contracts. Another reason for choosing OTC contracts is because they are not advertised to the market there are very little regulatory requirements associated with them.
Trading Basics
There are two ways you can trade options either as an option holder or an option writer. Below takes a look at the trades from both sides:
Option Holder
Long call: An investor who predicts a stock's price will increase may buy the right to purchase the stock (a call option) rather than just purchase the stock itself. There is no obligation to buy the stock, only the right to do so until the expiration date. If the stock price at expiration is above the exercise price by more than the premium paid then the investor will realize a profit. If the stock price at expiration is lower than the exercise price then the investor will let the call contract expire worthless. The only loss on the trade will be the amount paid for the premium. An investor may buy the option instead of shares because they can gain a larger exposure without outlaying more cash. This is known as leverage.
Long put: An investor who predicts a stock's price will decrease can buy the right to sell the stock at a fixed price (a put option). They will be under no obligation to sell the stock but have the right to do so until the expiration date. If the stock price at expiration is below the exercise price by more than the premium paid then the investor will realize a profit. If the stock price at expiration is above the exercise price they will let the put contract expire worthless and only lose the premium paid.
Option Writer
Short call: An investor who believes that a stock price will decrease can sell the stock short or instead sell or "write" a call option. The investor 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. Because prices can only decrease to zero but can increase to any price the potential loss on a short call is unlimited.
Short put: An investor who believes that a stock price will increase can buy the stock or instead sell, or "write" a put option. The investor selling a put has an obligation to buy the stock from the put buyer at the put buyer's option. If the stock price at expiration is above the exercise price the short put position will make a profit in the amount of the premium. If the stock price at expiration is below the exercise price by more than the amount of the premium the investor will lose money with the potential loss being up to the full value of the stock.
Summary
- An option is a contract giving the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date.
- Options are derivatives because they derive their value from an underlying asset.
- A call gives the holder the right to buy an asset at a certain price within a specific period of time.
- A put gives the holder the right to sell an asset at a certain price within a specific period of time.
- There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts.
- Most stock option contracts represent 100 shares of the underlying stock.
- Investors use options both to speculate and hedge risk.
- Buyers are often referred to as holders and sellers are also referred to as writers.
- The price at which an underlying stock can be purchased or sold is called the strike price.
- The total cost of an option is called the premium
- the definition of an option
- difference between a call and put option
- the various option styles
- overview of option trading
- advantages and disadvantages options offer
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