Options are a type of derivative security. They are a derivative because the price of an option is intrinsically linked to the price of something else. Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option. People somewhat familiar with derivatives may not see an obvious difference between this definition and what a future or forward contract does. The answer is that futures or forwards confer both the right and obligation to buy or sell at some point in the future. For example, somebody short a futures contract for cattle is obliged to deliver physical cows to a buyer unless they close out their positions before expiration. An options contract does not carry the same obligation, which is precisely why it is called an “option.”
Call and Put Options
A call option might be thought of as a deposit for a future purpose. For example, a land developer may want the right to purchase a vacant lot in the future, but will only want to exercise that right if certain zoning laws are put into place. The developer can buy a call option from the landowner to buy the lot at say $250,000 at any point in the next 3 years. Of course, the landowner will not grant such an option for free, the developer needs to contribute a down payment to lock in that right. With respect to options, this cost is known as the premium, and is the price of the options contract. In this example, the premium might be $6,000 that the developer pays the landowner. Two years have passed, and now the zoning has been approved; the developer exercises his option and buys the land for $250,000 – even though the market value of that plot has doubled. In an alternative scenario, the zoning approval doesn’t come through until year 4, one year past the expiration of this option. Now the developer must pay market price. In either case, the landowner keeps the $6,000.
A put option, on the other hand, might be thought of as an insurance policy. Our land developer owns a large portfolio of blue chip stocks and is worried that there might be a recession within the next two years. He wants to be sure that if a bear market hits, his portfolio won’t lose more than 10% of its value. If the S&P 500 is currently trading at 2500, he can purchase a put option giving him the right to sell the index at 2250 at any point in the next two years. If in six months time the market crashes by 20%, 500 points in his portfolio, he has made 250 points by being able to sell the index at 2250 when it is trading at 2000 – a combined loss of just 10%. In fact, even if the market drops to zero, he will still only lose 10% given his put option. Again, purchasing the option will carry a cost (its premium) and if the market doesn’t drop during that period the premium is lost.
These examples demonstrate a couple of very important points. First, when you buy an option, you have a right but not an obligation to do something with it. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, however, you lose 100% of your investment, which is the money you used to pay for the option premium. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are derivatives. In this tutorial, the underlying asset will typically be a stock or stock index, but options are actively traded on all sorts of financial securities such as bonds, foreign currencies, commodities, and even other derivatives.
Buying and Selling Calls and Puts: Four Cardinal Coordinates
Owning a call option gives you a long position in the market, and therefore the seller of a call option is a short position. Owning a put option gives you a short position in the market, and selling a put is a long position. Keeping these four straight is crucial as they relate to the four things you can do with options: buy calls; sell calls; buy puts; and sell puts.
People who buy options are called holders and those who sell options are called writers of options. Here is the important distinction between buyers and sellers:
- Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. This limits the risk of buyers of options, so that the most they can ever lose is the premium of their options.
- Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have unlimited risk, meaning that they can lose much more than the price of the options premium.
Don't worry if this seems confusing – it is. For this reason we are going to look at options primarily from the point of view of the buyer. At this point, it is sufficient to understand that there are two sides of an options contract.
To understand options, you'll also have to first know the terminology associated with the options market.
The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date. In our example above, the strike price for the S&P 500 put option was 2250.
The expiration date, or expiry of an option is the exact date that the contract terminates.
An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).
For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. An option is out-of-the-money if the price of the underlying remains below the strike price (for a call), or above the strike price (for a put). An option is at-the-money when the price of the underlying is on or very close to the strike price.
As mentioned above, the total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining the premium of an option is complicated and largely beyond the scope of this tutorial, although we will discuss it briefly.
Although employee stock options aren't available for just anyone to trade, this type of option could, in a way, be classified as a type of call option. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, exists only between the holder and the company and cannot typically be exchanged with anybody else, whereas a normal option is a contract between two parties that are completely unrelated to the company and can be traded freely.
Options Basics: Why Use Options?
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