Options
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Wikipedia-Article "Options"
- This article is about the finance term. For the American Football system, please see option offense.
In finance, an option is a contract whereby one party (the holder or buyer) has the right but not the obligation to exercise[2] a feature of the contract (the option) on or before a future date (the exercise date or expiry). The other party (the writer or seller) has the obligation to honour the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer has received something of value. The amount the buyer pays the seller for the option is called the option premium.
Most often the term "option" refers to a type of derivative which gives the holder of the option the right but not the obligation to purchase (a "call option") or sell (a "put option") a specified amount of a security within a specified time span. (Specific features of options on securities differ by the type of the underlying instrument involved.)
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Types of Option
Historical Uses of Options
Contracts similar to options are believed to have been used since ancient times. For example, Aristotle wrote about Thales, who bought the option to use olive presses during the next harvest. In the real estate market, call options have long been used to assemble large parcels of land from separate owners, e.g. a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the right — but not the obligation — to dramatize a specific book or script. Lines of credit give the potential borrower the right — but not the obligation — to borrow within a specified time period.
Many choices, or embedded options, have traditionally been included in bond contracts. For example many bonds are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early.
Privileges were options sold over the counter in 19th century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was fixed at the market price on the day the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets.
Real Options
- see main article: Real options
A real option is a choice that an investor has when investing in the real economy (i.e. in the production of goods or services, rather than in financial contracts). This option may be something as simple as the opportunity to expand production, or to change production inputs. Real options are an increasingly influential tool in corporate finance. They are typically difficult or impossible to trade, so lack the liquidity of exchange-traded options.
Traded Options
- also called "Exchange-Traded Options" or "Listed Options"
Traded Options are Exchange traded derivatives, as the name implies. As for other classes of exchange traded derivatives, they have: standardised contracts; quick systematic pricing; and are settled though a clearing house (ensuring fulfilment.)
Vanilla and Exotic Options
Generally speaking a vanilla option is a 'simple' or well understood option, whereas an exotic option is more complex, newer, or less easily understood.
The option contract
For the option purchaser (also called the holder or taker), the option:
- offers the right (but imposes no obligation),
- to buy (call option) or sell (put option)
- a specific quantity (e.g. 1 contract= 100 shares)
- of a given financial underlying (e.g. shares)
- at an agreed price (exercise or strike price), or calculable value. For example the value can be calculated based on a reference rate or something else such as the average price of an underlying asset, as measured at agreed-upon intervals during the life of a contract, i.e. the Asian option.
- on one or more call dates
- in exchange for a premium (option price).
The counterparty (option writer / seller) has an obligation to fulfill the contract if the option holder exercises the option. In return, the option seller receives the option price or premium.
Option frameworks
- The buyer assumes a long position, and the writer a corresponding short position. (Thus the writer of a call option, is "short a call" and has the obligation to sell to the holder, who is "long of a call option" and who has the right to buy. The writer of a put option is "on the short side of the position", and has the obligation to buy from the taker of the put option, who is "long a put".)
- The option style determines when the buyer may exercise the option. It will affect the valuation. Generally the contract will either be American style' - which allows exercise up to the expiry date - or European style - where exercise is only allowed on the expiry date - or Bermudan style - where exercise is allowed on several, specific dates up to the expiry date. European contracts are easier to value.
- Buyers and sellers of options do not (usually) interact directly - the futures and options exchange acts as intermediary. The seller guarantees the exchange that he can fulfill his obligation if the buyer chooses to execute.
- The risk for the option holder is limited: he cannot lose more than the premium paid as he can "abandon the option"[1]. His potential gain is theoretically unlimited; see strike price.
- The maximum loss for the writer of a put option is equal to the strike price. In general, the risk for the writer of a call option is unlimited. However, an option writer who owns the underlying instrument has created a covered position; he can always meet his obligations by using the actual underlying. Where the seller does not own the underlying on which he has written the option, he is called a "naked writer", and has created a "naked position".
- Options can be in-the-money, at-the-money or out-of-the-money. The "in-the-money" option has a positive intrinsic value, options in "at-the-money" or "out-of-the-money" have an intrinsic value of zero. Additional to the intrinsic value an option has a time value, which decreases the closer the option is to its expiry date.
Option pricing models
Historically the pricing of options was entirely ad hoc. Traders with good intuition about how other traders would price options made money and those without it lost money. Then in 1973 Fischer Black and Myron Scholes published a paper proposing what became known as the Black-Scholes pricing model, and for which Scholes received the 1997 Nobel Prize (Black had died, and was therefore not eligible). The model gave a theoretical value for simple put and call options, given assumptions about the behavior of stock prices. The availability of a good estimate of an option's theoretical price contributed to the explosion of trading in options. Researchers have subsequently generalized Black-Scholes to the Black model, and have developed other methods of option valuation, including Monte Carlo methods and Binomial options models.
Option uses
One can combine options and other derivatives in a process known as financial engineering to control the risk in a given transaction. The risk taken on can be anywhere from zero to infinite, depending on the combination of derivative features used.
Note, by using options, one party transfers (buys or sells) risk to or from another. When using options for insurance, the option holder reduces the risk he bears by paying the option seller a premium to assume it.
Because one can use options to assume risk, one can purchase options to create leverage. The payoff to purchasing an option can be much greater than by purchasing the underlying instrument directly. For example buying an at-the-money call option for 2 monetary units per share for a total of 200 units on a security priced at 20 units, will lead to a 100% return on premium if the option is exercised when the underlying security's price has risen by 2 units, whereas buying the security directly for 20 units per share, would have led to a 10% return. The greater leverage comes at the cost of greater risk of losing 100% of the option premium if the underlying security does not rise in price.
Other instruments to manage risk or to assume it include:
Employee stock options are also widely used as a compensation vehicle for employees and, in particular, senior executives of publicy traded corporations. However, employee stock options use is being curbed thanks in part to a decision by the Financial Accounting Standards Board (FASB) requiring that stock option grants are recorded on the income statement as an expense. Previously, options granted with fair market value exercise prices were not considered to have a cost to the company. This was a significant factor in their ascendancy as a compensation tool.
The Four Basic Option Trades
These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging.
- Long Call
A trader who believes that a stock's price will increase may buy the stock or instead, buy the right to purchase the stock (a call option). He has no obligation to buy the stock, only the right to do so until the expiry date. If the stock price increases by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium.
- Short Call (Naked short call)
A trader who believes that a stock's price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases, the short position will lose by the amount of the increase less the amount of the premium.
- Long Put
A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiry date. If the stock price decreases, he will profit by the amount of the decrease less the premium paid. If the stock price increases, he will just let the put contract expire worthless.
- Short Put
A trader who believes that a stock's price will increase can sell the right to purchase the stock at a fixed price. This trade is generally considered inappropriate for a small investor. If the stock price increases, the short put position will make a profit in the amount of the premium. If the stock price decreases, the short position will lose by the amount of the decrease less the amount of the premium.
Introduction to Option Strategies
Combining any of the four basic kinds of option trades (possibly with different exercise prices) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.
- Covered Call
Long the stock, short a call. This has essentially the same payoff as a short put.
Long a call and long a put with the same exercise prices (a long straddle), or short a call and short a put with the same exercise prices (a short straddle).
- Strangle
Long a call and long a put with different exercise prices (a long strangle), or short a call and short a put with different exercise prices (a short strangle).
- Bull Spread
Long a call with a low exercise price and short a call with a higher exercise price, or long a put with a low exercise price and short a put with a higher exercise price.
- Bear Spread
Short a call with a low exercise price and long a call with a higher exercise price, or short a put with a low exercise price and long a put with a higher exercise price.
- Butterfly
Butterflies require trading options with 3 different exercise prices. Assume exercise prices X1 < X2 < X3 and that (X1 + X3)/2 = X2
Long butterfly - long 1 call with exercise price X1, short 2 calls with exercise price X2, and long 1 call with exercise price X3. Alternatively, long 1 put with exercise price X1, short 2 puts with exercise price X2, and long 1 put with exercise price X3.
Short butterfly - short 1 call with exercise price X1, long 2 calls with exercise price X2, and short 1 call with exercise price X3. Alternatively, short 1 put with exercise price X1, long 2 puts with exercise price X2, and short 1 put with exercise price X3.
Footnote
- 1. ^ in options, to abandon or abandonment means allowing the option to expire unexercised
- 2. ^ in options, exercise means executing the right of the option to buy or sell the underlying security
See also
Related: Call option, put option, moneyness, option time value, put-call parity, Black-Scholes, Black model, binomial options model, volatility smile, option adjusted spread
Options: Stock option, warrant, foreign exchange option, bond option, options on futures, swaption, interest rate cap and floor, credit default option, binary option, real option, option (films)
Finance articles: Derivatives market, financial mathematics, financial economics, finance, list of finance topics, list of finance topics (alphabetical)
External links
- Chicago Board Options Exchange
- Derivative One, Option Valuation and Calculators
- Disk Lectures, Options I audio lecture with slideshow
- ESOManager, Employee Stock Option Valuation
- Futures Quotes, Daily and historical options prices for commonly traded futures
- Global Derivatives, Options database
- Investopedia, Options tutorial
- Options books
- Options Clearing Corporation The largest clearing organization in the world for options
- Options Industry Council, Options Education, benefits and risks of exchange-traded equity options
- Quant Notes, Fundamentals of Options
- Stock Options Info, Daily Stock Options News and Information
- Yahoo, Yahoo! Finance Options Glossary