What is an Option?
Options are not to be confused with futures, as they are
two separate financial instruments.
The option seller has the corresponding obligation to fulfill the
transaction – to sell or buy – if the buyer (owner) ‘exercises’ the option. The
underlying asset/instrument could be a stock, bond, foreign currency,
commodity, or any other traded instrument. Exercising means utilising the right
to buy or sell the underlying security.
Usually, an option contract should include the following specifications:
Type: whether the option holder has the right to buy (a call option) or
the right to sell (a put option).
- Underlying asset and
quantity: the
quantity and the underlying asset(s) (e.g.: 100 shares of Apple.Inc stock)
- Strike price: the stated price where
the buyer will exercise the option
- Expiry date: the last date the option
can be exercised
- Settlement terms: for instance, whether
the option seller (writer) must deliver the actual asset on exercise, or
whether he/she will simply tender the equivalent cash amount
- Option premium: the total amount you
pay for the option.
Why Use Options?
There are two types of options: Call and Put. Call options
allow the owner to buy a specified amount of underlying asset at a fixed price
within a specific period of time while put options allow the holder to sell a
specified amount of underlying asset at the strike price within a specific timeframe.
An option can also be categorised by American or European style. American
options can be exercised any time before the expiration date of the option,
while European options can only be exercised on the expiration date. When you
buy an option, the purchase price is called the premium. If you sell your
option, the premium is the amount you receive. The premium isn’t fixed and may
fluctuate based on market conditions.
Aside from providing investors with the right to buy or sell underlying
assets, there are various use cases for options1:
Versatile
securities
The advantage of options is that you are not limited to making a profit
only when the market goes up. Because of the versatile nature of options, you
can also make money when the market goes down or even when it moves sideways.
Speculation
If you buy an options contract, you are betting on the movement of the
security. This kind of bet requires extensive knowledge of financial markets
and a high risk tolerance.
Hedging
Options are used as an insurance policy to protect your stocks against a
potential downturn.
Options to attract
employees
Many companies use stock options as a way to attract and keep talented
employees.
Different Types of
Options
As mentioned before, the strike price for an option is the price at
which the underlying asset is bought or sold if the option is exercised. The
relationship between the strike price and the actual price of a stock
determines, in the unique language of options, whether the option is
in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM)2.
In the money (ITM)
For call options, in-the-money means that strike price is below the
actual stock price.
Example: An investor purchases a call option at the $95 strike price for XYZ that
is currently trading at $10. The investor’s position is in the money by $5. The
call option gives the investor the right to buy the equity at $95.
For put options, in-the-money means that strike price is above the
actual stock price.
Example: An investor purchases a put option at the $110 strike price for XYZ that
is currently trading at $100. This investor position is in-the-money by $10.
The put option gives the investor the right to sell the equity at $110.
At the money (ATM)
For both put and call options, the strike and the actual stock prices
are the same.
Out-of-the-money
(OTM)
An out-of-the-money call option strike price is above the actual stock
price.
Example: An investor purchases an out-of-the-money call option at the
strike price of $110 for XYZ that is currently trading at $100. This investor’s
position is out-of-the-money by $10. An out-of-the-money put option strike
price is below the actual stock price.
Example: An investor purchases an out-of-the-money put option at the strike
price of $95 for XYZ that is currently trading at $100. This investor’s
position is out of the money by $5.
Payoff
You have now familiarised yourself with option basics. Now, let’s take a
look at how option works and how the payoff can be derived. Payoff diagrams are
charts that illustrate the profit/loss of the option as its underlying price
changes, and the conditions include: long-call, short-call, long-put, and
short-put.
Long-Call
Bob is bullish on Apple Inc. because he believes the new iPhone will
have more functions and will subsequently give the stock a good bump.
Rather than buying shares, Bob is looking at a long position with call options,
as they limit his downside while still allowing unlimited gains if the
stock price blows up. Here are some facts about his position and what the
payoff will look like at various stock prices:
Given: option premium per share = $2, option strike price=$100
The breakeven point is the stock price at which an
investor’s net profit will be zero:
Breakeven stock price = Strike price + premium
In this case, the breakeven price is $100 + $2 = $102. Another feature
to note is that if the stock price is below the strike price, Bob will just let
the options expire without using them and his losses will be limited to the
premium he paid for the options. On the other hand, the profits are unlimited
as the price goes higher than $102.
Here is a formula:
Call payoff per share = MAX (stock price – strike price, 0) – premium
per share
At a stock price of $98, MAX ($98 – $100, 0) – $2 = 0 – $2 = $2 per share
loss
At a stock price of $105, MAX ($105 – $100, 0) – $2 = $5 – $2 = $3
profit per share
Short-Call
The writer (seller) of the call option takes a short or opposite
position. His payoff graph is the opposite of the long-call we mentioned.
Profits are limited to the premium he collects when the strike price exceeds
the stock price and the calls are allowed to lapse. Above the strike price he
faces increasing losses as the stock price increases.
The payoff formula is:
Short call payoff per share = premium per share – MAX (0, share price –
strike price)
Long-Put
In this circumstance, Bob is bearish on Apple.Inc stock as he feels that
the new iPhone may be overhyped due to public anticipation. He might therefore
buy a long-put option of Apple stock, through which he gains interest as long
as the stock price drops below the breakeven price. His loss is also limited to
the paid premium and the gain can reach a maximum when the stock price drops to
0.
Given: option premium per share = $2, option strike price=$100
Breakeven stock price = Strike price – Premium
In this case, the breakeven price is $100 – $2 = $98. If the stock price
is above the strike price, Bob will just let the options expire without using
them and his losses will be limited to the premium he paid for the options. On
the other hand, his profits are also limited as the price can go lower than $98
and reach the maximum when the price is zero.
Here is a formula:
Put payoff per share = MAX (strike price – stock price, 0) – premium per
share
At a stock price of $103, MAX ($100 – $103, 0) – $2 = 0 – $2 = $2 per
share loss
At a stock price of $95, MAX ($100 – $95, 0) – $2 = $5 – $2 = $3 profit
per share
Short-Put
The writer (seller) of the put option takes a short or opposite
position. His payoff graph is the opposite of the long-put position illustrated
above. Profits are limited to the premium he collects when the stock price
exceeds the strike price and the put options are allowed to lapse. Below the
strike price he faces increasing losses as the stock price decreases.
The payoff formula is:
Short put payoff per share = premium per share – (MAX (0, strike
price-share price)
