What are options?

Options are contracts that give the purchaser the right, but not the obligation, to buy or sell a security, at a fixed price within a specific period of time. Options are known as derivative investments because their value is derived from the value of the underlying stock (when buying or selling options on stocks) or commodity (when buying or selling options on commodity futures).

Options are traded on a number of exchanges, including the Chicago Board Options Exchange (CBOE) and International Securities Exchange (ICE).

Important Option Terms

Exercising the option - This is the buying or selling of the underlying asset via the option contract.

Strike or exercise price - This is the fixed price in the option contract at which the holder (investor) can buy or sell the underlying asset (e.g. stock).

Expiration date - The maturity date of the option; the option doesn't exist after this date.

Premium – this is the additional cost that one needs to pay in order to have the rights, but no the obligation to buy or sell a security at a fixed price.

Breakeven points - this is the market price that an underling asset must reach for an option buyer to avoid a loss if they exercise the option. For the call buyer, the BEP is the strike price plus premium paid while BEP for put position is the strike price minus premium paid.

American option - can be exercised anytime during its lifetime and not only at its expiration. These normally trade on standardized exchanges.

European options - can only be exercised at maturity/expiration. These tend to trade at a discount compared to American options due to a lower degree of flexibility. European options normally trade over the counter.

Types of options

  • Call option

This gives the buyer of the option the right but not the obligation to buy a stock, bond or commodity (or any underlying asset) at a specified price within a specified time period. In this way therefore, the option buyer would want that the stock price on the market to rise so that he can buy it, by exercising the option, at a pre-determined price which was lower and hence make a profit.

The maximum profit that the call option buyer can make is limitless as it is subject to how much the price of the underlying rises. The maximum loss the call option buyer can make is the cost for the premium to purchase the option since if the price goes down more than the pre-determined strike price, the option expires without being exercised.

Here we can see a simple Long CALL strategy (bullish strategy):

The premium to buy this call is $200 whilst the strike price is $40. If the price of the underlying instrument is currently $50, it makes sense to exercise the option at $40 and sell it at the open market for $50 thereby making a profit. The market price can of course go higher and hence the maximum profit is theoretically unlimited.

If on the other hand the price of the underlying is currently $30, it does not make sense to exercise the option at $40 and hence the option expires worthless. The maximum loss in this case would be the premium ($200).

Conversely the option writer (seller) who sells the call option believes that the underlying stock price will drop or stay relatively the same as the exercising price. In this case therefore, you have an obligation to sell the underlying instrument. The maximum profit the option writer can make is limited to the premium whilst the maximum loss can be unlimited due to stock price rising higher on the open market.

Here we can see a simple Short CALL Strategy (bearish strategy):

The maximum gain is $300 (Premium).

The best scenario for the option writer is that the stock price is at or below strike price ($50). If market price is currently at $48, the option writer benefits as he gets the premium. If on the other hand underlying stock price is more than $53 (BEP), the loss can be unlimited as price can go to infinity and the option writer has the obligation to sell the underlying instrument at the pre-determined price which when exercised, would be less than the current market price and therefore make a loss.

  • Put options

A Put is an options contract that gives the buyer the right, but not the obligation to sell the underlying asset at the strike price at any time up to the expiration date. In this way therefore, the option buyer would want the stock price on the market to decline so that he can buy it on the market at a lower price and sell it, by exercising the option, at the higher pre-determined price hence making a profit.

The maximum profit a put option buyer can make is unlimited (i.e. until the price reaches zero). Maximum loss is limited to the premium if option expires.

Here we can see a simple Long Put option (Bearish Strategy)

 

In this example the strike price is $40 and a premium of $200.

Here you are agreeing that you want to sell in the future for $40 per share. Your goal is therefore to buy shares at a lower price (e.g. $30 per share) and sell them at a higher price in the future (you had already agreed this with the put option).In this way therefore, you are forecasting that the price is going down and you will profit from it.

Maximum loss is limited and is incurred if the trader still holds the put option at expiration and the stock is above the strike price. The option would thus expire worthless and the loss would be the price paid for the put option ($200 in this example).

Profit potential is theoretically unlimited to zero (i.e. the best that can happen is for the stock price to drop to $0).

Breakeven point is $40 - $2 = $30

Conversely the option writer (seller) is the one who sells the put option and believes that the underlying stock price will rise or stay relatively the same as the exercising price. In this case therefore, you have an obligation to sell the underlying instrument. The maximum profit the option writer can make is limited to the premium whilst the maximum loss can be unlimited due to price declining more on the open market as opposed to the strike price.

Here we can see a simple Short Put Strategy (bullish strategy)

You expect a steady rise in the price in the stock price and the likelihood of a decline very remote.

Maximum theoretical loss is limited (stock price fall to zero and thus investor has to buy a stock at $45 although its price is zero).

Profit potential is limited to the premium you took during the sale of the put.

The best scenario is for the stock price to be anywhere above the strike price at expiration. In that case, the option expires worthless and you never have to do anything to close the trade.

Breakeven point will be when at expiration, the price is equal to strike price minus premium. Anything above this level at expiration would move towards your maximum profit.

Example
Price is $50 and you will be receiving $200 as premium immediately.
Maximum Loss = Unlimited
Maximum Profit = $200 premium

In/Out/At the Money

When you buy a call options, this can be In the Money, Out of the Money or At the money.

  • In the Money means the underlying asset price is above the call strike price.
  • Out of the Money means the underlying asset price is below the call strike price.
  • At the money means the strike price and underlying asset price are the same.

Your premium will be larger for an In the Money option (because it already has intrinsic value), while your premium will be lower for Out of the Money call options.

When you buy a Put option, this can also be be In the Money, or Out of the Money.

  • In the Money means the underlying asset price is below the put strike price.
  • Out of the Money means the underlying asset price is above the put strike price.
  • At the money means the strike price and underlying asset price are the same.

Your premium will be larger for an In the Money option (because it already has intrinsic value), while your premium will be lower for Out of the Money put options.