An option is common form of a derivative. It's a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. Options can be embedded into many kinds of contracts. For example, a corporation might issue a bond with an option that will allow the company to buy the bonds back in ten years at a set price. Standalone options trade on exchanges or OTC. They are linked to a variety of underlying assets. Most exchange-traded options have stocks as their underlying asset but OTC-traded options have a huge variety of underlying assets (bonds, currencies, commodities, swaps, or baskets of assets).
There are two main types of options: calls and puts:
- Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ''writing'' an option.
- Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. Put buyers - those who hold a "long" - put are either speculative buyers looking for leverage or "insurance" buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a "short" expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlyer is at or above the option's strike price at expiration. The maximum loss is unlimited for an uncovered put writer.
To obtain these rights, the buyer must pay an option premium (price). This is the amount of cash the buyer pays the seller to obtain the right that the option is granting them. The premium is paid when the contract is initiated.
In Level 1, the candidate is expected to know exactly what role short and long positions take, how price movements affect those positions and how to calculate the value of the options for both short and long positions given different market scenarios. For example:
Q. Which of the following statements about the value of a call option at expiration is FALSE?A. The short position in the same call option can result in a loss if the stock price exceeds the exercise price.
B. The value of the long position equals zero or the stock price minus the exercise price, whichever is higher.
C. The value of the long position equals zero or the exercise price minus the stock price, whichever is higher.
D. The short position in the same call option has a zero value for all stock prices equal to or less than the exercise price.
A. The correct answer is "C". The value of a long position is calculated as exercise price minus stock price. The maximum loss in a long put is limited to the price of the premium (the cost of buying the put option). Answer "A" is incorrect because it describes a gain. Answer "D" is incorrect because the value can be less than zero (i.e. an uncovered put writer can experience huge losses).
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