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).

Swaps


Related Articles
  1. Professionals

    Calls And Puts

    Calls And Puts
  2. Professionals

    Options: Calls and Puts

    CFA Level 1 - Options: Calls and Puts. Learn the two main types of option derivatives and how each benefits its holder. Provides an example multiple choice question for an option.
  3. Professionals

    F. Characteristics of All Options

    All option contracts are issued and their performance is guaranteed by the Options Clearing Corporation (OCC). Standardized options trade on the exchanges, such as the Chicago Board Options Exchange ...
  4. Options & Futures

    Options Pricing: The Basics Of Pricing

    The price, or cost, of an option is an amount of money known as the premium. The buyer pays this premium to the seller in exchange for the right granted by the option. For example, a buyer might ...
  5. Professionals

    Possible Outcomes For An Option

    Exercised If the option is exercised, the buyer has elected to exercise their rights to buy or sell the stock depending on the type of option involved. Exercising an option obligates the seller ...
  6. Options & Futures

    Three Ways to Profit Using Put Options

    A brief overview of how to profit from using put options in your portfolio.
  7. Options & Futures

    Options Basics: What Are Options?

    An option is a contract that gives 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. An option, just like a stock ...
  8. Options & Futures

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  9. Options & Futures

    4 Reasons To Hold Onto An Option

    There are times when an investor shouldn't exercise an option. Find out when to hold and when to fold.
  10. Options Seller Traders

    In contrast to buying options, an options seller trader sells stock options. This comes with an obligation to sell the underlying equity to a buyer if that buyer decides to exercise the option ...
RELATED TERMS
  1. Call On A Call

    A type of compound option in which the investor has the right ...
  2. Call Over

    When the buyer of a call option exercises the option. In options ...
  3. Exercise

    To put into effect the right specified in a contract. In options ...
  4. Put On A Call

    One of the four types of compound options, this is a "put" option ...
  5. Early Exercise

    The exercise of an option prior to its expiration date. Early ...
  6. Exercise Price

    The price at which the underlying security can be purchased (call ...
RELATED FAQS
  1. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  2. When holding an option through expiration date, are you automatically paid any profits, ...

    Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might ... Read Answer >>
  3. After exercising a put option, can I still hold my option contract in order to sell ...

    Once a put option contract has been exercised, that contract does not exist anymore. A put option grants you the right to ... Read Answer >>
  4. How are call options priced?

    Learn how aspects of an underlying security such as stock price and potential for fluctuations in that price, affect the ... Read Answer >>
  5. When is a put option considered to be "in the money"?

    Learn about put options, what they are, how these financial derivatives operate and when put options are considered to be ... Read Answer >>
  6. What is the difference between "right" and "obligation" on a call option?

    Learn what a call option is, what determines a buyer and seller of an option, and what the difference between a right and ... Read Answer >>
Hot Definitions
  1. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  2. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  3. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  4. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  5. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  6. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
Trading Center