Derivatives - Options: Basic Characteristics
Both put and call options have three basic characteristics: exercise price, expiration date and time to expiration.
- The buyer has the right to buy or sell the asset.
- To acquire the right of an option, the buyer of the option must pay a price to the seller. This is called the option price or the premium.
- The exercise price is also called the fixed price, strike price or just the strike and is determined at the beginning of the transaction. It is the fixed price at which the holder of the call or put can buy or sell the underlying asset.
- Exercising is using this right the option grants you to buy or sell the underlying asset. The seller may have a potential commitment to buy or sell the asset if the buyer exercises his right on the option.
- The expiration date is the final date that the option holder has to exercise her right to buy or sell the underlying asset.
- Time to expiration is the amount of time from the purchase of the option until the expiration date. At expiration, the call holder will pay the exercise price and receive the underlying securities (or an equivalent cash settlement) if the option expires in the money. (We will discuss the degrees of moneyness later in this session.) The call seller will deliver the securities at the exercise price and receive the cash value of those securities or receive equivalent cash settlement in lieu of delivering the securities.
- Defaults on options work the same way as they do with forward contracts. Defaults on over-the counter option transactions are based on counterparties, while exchange-traded options use a clearing house.
Example: Call Option
IBM is trading at 100 today. (June 1, 2005)
The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on the call = $3
In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for the right to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercise the option on or before August 1, 2005, the seller will have to deliver IBM shares at a price of $125 to the buyer.
Example: Put Option
IBM is trading at 100 today (June 1, 2005)
Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put = $3.00
In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right to sell IBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise the option on or before August 1, 2005, the seller will have to purchase IBM shares at a price of $90.
Example: Interpreting Diagrams
For the exam, you may be asked interpret diagrams such as the following, which shows the value of a put option at expiration.
A typical question about this diagram might be:
Q: Ignoring transaction costs, which of the following statements about the value of the put option at expiration is TRUE?A. The value of the short position in the put is $4 if the stock price is $76.
B. The value of the long position in the put is $4 if the stock price is $76.
C. The long put has value when the stock price is below the $80 exercise price.
D. The value of the short position in the put is zero for stock prices equaling or exceeding $76.
The correct answer is "C". A put option has positive monetary value when the underlying instrument has a current price ($76) below the exercise price ($80).
Career Education & ResourcesLearn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
ProfessionalsA financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
Career Education & ResourcesRead about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
Career Education & ResourcesLearn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
Career Education & ResourcesThe non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
Career Education & ResourcesLearn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
Your PracticeThese four professional organizations are among the most respected and well known in the industry.
ProfessionalsFind out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
ProfessionalsThe Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
ProfessionalsLearn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
Professionals who help individuals manage their finances by providing ...
Formerly known as the Association for Investment Management and ...
A professional designation given by the CFA Institute (formerly ...
A financial professional who studies various industries and companies, ...
The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>