Beginners Guide to Options

What is an option?

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date.

An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock (equity). In the case of an index option, its value is based on the underlying index (equity).

An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.

 

Options vs. Stocks
 

Similarities:

· Listed Options are securities, just like stocks.
· Options trade like stocks, with buyers making bids and sellers making offers.
· Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.

Differences:

· Options are derivatives, unlike stocks (i.e, options derive their value from something else, the underlying security).
· Options have expiration dates, while stocks do not.
· There is not a fixed number of options, as there are with stock shares available.
· Stockowners have a share of the company, with voting and dividend rights. Options convey no such rights.

Call Options and Put Options

Some people remain puzzled by options. The truth is that most people have been using options for some time, because option-ality is built into everything from mortgages to auto insurance. In the listed options world, however, their existence is much more clear.

To begin, there are only two kinds of options: Call Options and Put Options.

A Call option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits.

If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned.

If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument increases.

When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price, called the strike price.

If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.

Put options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies.

If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases.

If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.

With a Put option, you can "insure" a stock by fixing a selling price.

If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level.

If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium.

This is the primary function of listed options, to allow investors ways to manage risk.

Types Of Expiration

There are two different types of options with respect to expiration. There is a European style option and an American style option. The European style option cannot be exercised until the expiration date. Once an investor has purchased the option, it must be held until expiration. An American style option can be exercised at any time after it is purchased. Today, most stock options which are traded are American style options. And many index options are American style. However, there are many index options which are European style options. An investor should be aware of this when considering the purchase of an index option.

Options Premiums

An option Premium is the price of the option. It is the price you pay to purchase the option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZ stock) may have an option premium of Rs.2.

This means that this option costs Rs. 200.00. Why? Because most listed options are for 100 shares of stock, and all equity option prices are quoted on a per share basis, so they need to be multiplied times 100. More in-depth pricing concepts will be covered in detail in other section.

Strike Price

The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract.

For example, with the XYZ May 30 Call, the strike price of 30 means the stock can be bought for Rs. 30 per share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock at Rs. 30 per share.

Expiration Date

The Expiration Date is the day on which the option is no longer valid and ceases to exist. The expiration date for all listed stock options in the U.S. is the third Friday of the month (except when it falls on a holiday, in which case it is on Thursday).

For example, the XYZ May 30 Call option will expire on the third Friday of May.

The strike price also helps to identify whether an option is in-the-money, at-the-money, or out-of-the-money when compared to the price of the underlying security. You will learn about these terms later.

Exercising Options

People who buy options have a Right, and that is the right to Exercise.

For a Call exercise, Call holders may buy stock at the strike price (from the Call seller).

For a Put exercise, Put holders may sell stock at the strike price (to the Put seller).

Neither Call holders nor Put holders are obligated to buy or sell; they simply have the rights to do so, and may choose to Exercise or not to Exercise based upon their own logic.

Assignment of Options

When an option holder chooses to exercise an option, a process begins to find a writer who is short the same kind of option (i.e., class, strike price and option type). Once found, that writer may be Assigned.

This means that when buyers exercise, sellers may be chosen to make good on their obligations.

For a Call assignment, Call writers are required to sell stock at the strike price to the Call holder.

For a Put assignment, Put writers are required to buy stock at the strike price from the Put holder.

Types of options

There are two types of options - call and put. A call gives the buyer the right, but not the obligation, to buy the underlying instrument. A put gives the buyer the right, but not the obligation, to sell the underlying instrument.

Selling a call means that you have sold the right, but not the obligation, for someone to buy something from you. Selling a put means that you have sold the right, but not the obligation, for someone to sell something to you.

Strike price

The predetermined price upon which the buyer and the seller of an option have agreed is the strike price, also called the exercise price or the striking price. Each option on a underlying instrument shall have multiple strike prices.

In the money:

Call option - underlying instrument price is higher than the strike price.
Put option - underlying instrument price is lower than the strike price.

Out of the money:
Call option - underlying instrument price is lower than the strike price.
Put option - underlying instrument price is higher than the strike price.

At the money:

The underlying price is equivalent to the strike price.

Expiration day

Options have finite lives. The expiration day of the option is the last day that the option owner can exercise the option. American options can be exercised any time before the expiration date at the owner's discretion.

Thus, the expiration and exercise days can be different. European options can only be exercised on the expiration day.

Underlying Instrument

A class of options is all the puts and calls on a particular underlying instrument. The something that an option gives a person the right to buy or sell is the underlying instrument. In case of index options, the underlying shall be an index like the Sensitive index (Sensex) or S&P CNX NIFTY or individual stocks.

Liquidating an option

An option can be liquidated in three ways A closing buy or sell, abandonment and exercising. Buying and selling of options are the most common methods of liquidation. An option gives the right to buy or sell a underlying instrument at a set price.

Call option owners can exercise their right to buy the underlying instrument. The put option holders can exercise their right to sell the underlying instrument. Only options holders can exercise the option.

In general, exercising an option is considered the equivalent of buying or selling the underlying instrument for a consideration. Options that are in-the-money are almost certain to be exercised at expiration.

The only exceptions are those options that are less in-the-money than the transactions costs to exercise them at expiration.

Most option exercise occur within a few days of expiration because the time premium has dropped to a negligible or non-existent level.

An option can be abandoned if the premium left is less than the transaction costs of liquidating the same.

Option Pricing

Options prices are set by the negotiations between buyers and sellers. Prices of options are influenced mainly by the expectations of future prices of the buyers and sellers and the relationship of the option's price with the price of the instrument.

An option price or premium has two components : intrinsic value and time or extrinsic value.

The intrinsic value of an option is a function of its price and the strike price. The intrinsic value equals the in-the-money amount of the option.
The time value of an option is the amount that the premium exceeds the intrinsic value. Time value = Option premium - intrinsic value.