SignUp to Newsletter

Introduction to Options

What are Options?

An option is defined as the right, not the obligation, to buy (or sell) an asset at a fixed price before a predetermined date.

Let's have a look at that definition and see if we can pick out the component parts:

  • The right, not the obligation
  • To buy or sell an asset
  • At a fixed price
  • Before a predetermined date

These component parts have important consequences on the valuation of an option.  Remember that the option itself has a value which we will look at after we finish with the definitions.

Before we go ahead and look at the ways in which options are valued, let's consider the words "right not the obligation":

The Right, not the Obligation

Buying gives you the Right

  • Buying an option (call or put) conveys the right, not the obligation to buy (call) or sell (put) an underlying instrument (eg a share).
  • When you buy an option you are NOT obligated to buy or sell the underlying instrument - you simply have the right to do so at the fixed (Exercise or Strike) price.
  • Your risk, when you buy an option, is simply the price you paid for it.

Selling (naked) imposes the Obligation

  • Selling an option (call or put) obliges you to buy (put) from or deliver (call) to the option buyer.
  • Selling options naked (ie when you have not bought a position in the underlying instrument or an option to hedge against it) will give you an unlimited risk profile.
  • Combined with the fact that you are obliged to do something, this is generally not a preferable position to put yourself in.

Now let's consider the words "to buy or sell an asset":

Types of Option - Calls and Puts

Memory Tip

Call is to Buy - think of calling up a friend - a call is the option to buy, you think the market is going up

The real reason it is named a call is because when you buy a call you can "call" the underlying asset away from the person who sold it to you.

Put is to Sell - think of a "put down" - a put is the option to sell, you think the market is going down

The real reason it is named a put is because when you buy a put you can "put" the underlying asset to the person who sold it to you.

  • A CALL is an option to BUY
  • A PUT is an option to SELL

Therefore:

  • A CALL option is the right, not the obligation to BUY an asset at a fixed price before a predetermined date
  • A PUT option is the right, not the obligation to SELL an asset at a fixed price before a predetermined date

Types of Calls and Puts

Options can be either American Style or European Style.

  • American Style options allow the option buyer to exercise the option at any time before the expiration date
  • European Style options do NOT allow the option buyer to exercise the option before the expiration date.

Most traded options are American Style and all US Equity options are American Style.

American Style options are slightly more valuable than European Style options because of their added flexibility.

Now we need to look at the words "at a fixed price":

Exercise (or Strike) Price

The Exercise (or Strike) Price is the fixed price at which the option can be exercised.

So if you buy a call option which has a strike price of $50, then you have bought yourself the option to buy the asset at a price of $50.

However, in the real world you only want to exercise your right to buy that asset at $50 if the underlying asset is actually worth more than $50 in the market.  If the underlying asset is below $50, there is no point in doing so because you'd be exercising your right to buy the asset for $50, when it's only actually worth, say, $40.  No-one would do that because they could buy it for $40 in the market.

This leads us to the words "before a predetermined date"

Expiration Date

This is the date before which the option can be exercised.

At expiration, the call option is only worth the price of the asset less the strike price.

At expiration the put option is only worth the strike price less the price of the asset.

(For US Equity Options the Expiration Dates fall on the 3rd Friday of every month)

Summary of Options Definition

Stocks

Options

Stocks consist of individual shares which are units of ownership in a corporation or organization.

Options are derivative instruments.  In other words their value is derived from the underlying stock (or underlying asset).

Individual shares go on in perpetuity (unless the corporation goes bust or is taken over).  They do not "expire" as such.

Options have expiration dates.  This means that options are wasting assets in that the passage of time will erode that portion of the option's value as the expiration date looms.

Stockholders are the owners of the company and have voting rights.  Stockholders are also entitled to dividend payments as and when they are paid.

Options convey no rights of ownership of the underlying asset.  They merely convey the right to buy or sell the underlying asset.

Why Options?

You can trade options in order to accomplish a variety of investment objectives.  Here are a few examples of how options can be useful coupled with examples of associated strategies:

Rationale Example of a Strategy
Insurance against existing positions
  • Synthetic Call
  • Collar
Income enhancement
  • Covered Call
  • Naked Put
Profit from declining stocks
  • Long Put
Profit from volatile stocks
  • Straddle
  • Strangle
Profit from range-bound stocks
  • Butterfly
  • Condor
Invest in stocks by paying less out of your trading account
  • Synthetic Future

LEAPs

You can also use options to apply longer-term strategies of up to 3 years for US stocks.

LEAPs are Long Term Equity Anticipation Securities.  In other words they are simply options with a longer time to expiration.

LEAPs have expiration dates of up to 3 years away (from when they are first listed) and are available for over 300 individual stocks and a number of indices in the US.