What is an Option?
An option is a standardized contract providing for the right – but not the obligation – to buy or sell an underlying financial instrument. For the Options Hunter this can be an underlying stock, exchange traded fund (ETF), or an index. The contract controls 100 shares, and is good until a defined expiration date. The price at which these contracts can be bought or sold also is known as the strike price.
There are two types of options: calls and puts. You can buy or sell either type of contract. If you buy an option you are the holder of the contract and considered to be “long,” while if you sell an option you are the “writer” of the contract and considered to be “short.” The Options Hunter only buys calls and puts, we never write options.
The buyer of a call has the right to buy the underlying security (e.g. 100 shares of Yahoo) at the strike price on or before the expiration date. The seller of a call has the obligation to sell the shares, if asked.
The buyer of a put has the right to sell the underlying security (e.g. 100 shares of Google) at the strike price on or before the expiration date. The seller of a put has the obligation to buy the shares, if asked.
Call option↑ Top
A call option, often simply labeled a “call”, is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or “writer”) is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price.
Call options are most profitable for the buyer when the underlying instrument moves up, making the price of the underlying instrument closer to, or above, the strike price. The call buyer believes it’s likely the price of the underlying asset will rise by the exercise date. The risk is limited to the premium. The profit for the buyer can be very large, and is limited by how high underlying’s spot rises. When the price of the underlying instrument surpasses the strike price, the option is said to be “in the money”.
The call writer does not believe the price of the underlying security is likely to rise. The writer sells the call to collect the premium. The total loss, for the call writer, can be very large, and is only limited by how high the underlying’s spot price rises.
Call options can be purchased on many financial instruments other than stock in a corporation. Options can be purchased on futures on interest rates, and on commodities like gold or crude oil.
An investor typically ‘buys a call’ when he expects the price of the underlying instrument will go above the call’s ‘strike price,’ hopefully significantly so, before the call expires. The investor pays a non-refundable premium for the legal right to exercise the call at the strike price, meaning he can purchase the underlying instrument at the strike price. Typically, if the price of the underlying instrument has surpassed the strike price, the buyer pays the strike price to actually purchase the underlying instrument, and then sells the instrument and pockets the profit. Of course, the investor can also hold onto the underlying instrument, if he feels it will continue to climb even higher.
Put option ↑ Top
A put or put option is a contract between two parties to exchange an asset, the underlying, for a specified amount of cash, the strike, by a predetermined future date, the expiry or maturity. One party, the buyer of the put, has the right, but not an obligation, to sell the asset at the strike price by the future date, while the other party, the seller, has the obligation to buy the asset at the strike price if the buyer exercises the option.The most widely-traded put options are on equities, but they are traded on many other instruments such as interest rates or commodities.
The put buyer either believes that the underlying asset’s price will fall by the exercise date or hopes to protect a long position in it. The advantage of buying a put over short selling the asset is that the option owner’s risk of loss is limited to the premium paid for it, whereas the asset short seller’s risk of loss is unlimited (its price can rise greatly, in fact, in theory it can rise infinitely, and such a rise is the short seller’s loss.) The put buyer’s prospect (risk) of gain is limited to the option’s strike price less the underlying’s spot price and the premium/fee paid for it.
The put writer believes that the underlying security’s price will rise, not fall. The writer sells the put to collect the premium. The put writer’s total potential loss is limited to the put’s strike price less the spot and premium already received. Puts can be used also to limit the writer’s portfolio risk and may be part of an option spread. The put buyer is short on the underlying asset of the put, but long on the put option itself. That is, the buyer wants the value of the put option to increase by a decline in the price of the underlying asset below the strike price. The writer (seller) of a put is long on the underlying asset and short on the put option itself. That is, the seller wants the option to become worthless by an increase in the price of the underlying asset above the strike price.
Generally, a put option that is purchased is referred to as a long put and a put option that is sold is referred to as a short put. A naked put, also called an uncovered put, is a put option whose writer (the seller) does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock, but only if the price is low enough. If the buyer fails to exercise the options, then the writer keeps the option premium as a ‘gift’ for playing the game.
If the underlying stock’s market price is below the option’s strike price when expiration arrives, the option owner (buyer) can exercise the put option, forcing the writer to buy the underlying stock at the strike price. That allows the exerciser (buyer) to profit from the difference between the stock’s market price and the option’s strike price. But if the stock’s market price is above the option’s strike price at the end of expiration day, the option expires worthless, and the owner’s loss is limited to the premium (fee) paid for it (the writer’s profit).
The seller’s potential loss on a naked put can be substantial. If the stock falls all the way to zero (bankruptcy), his loss is equal to the strike price (at which he must buy the stock to cover the option) minus the premium received. The potential upside is the premium received when selling the option: if the stock price is above the strike price at expiration, the option seller keeps the premium, and the option expires worthless. During the option’s lifetime, if the stock moves lower, the option’s premium may increase (depending on how far the stock falls and how much time passes). If it does, it becomes more costly to close the position (repurchase the put, sold earlier), resulting in a loss. If the stock price completely collapses before the put position is closed, the put writer potentially can face catastrophic loss. In order to protect the put buyer from default, the put writer is required to post margin. The put buyer does not need to post margin because the buyer would not exercise the option if it had a negative payoff.
Strike price↑ Top
In options, the strike price (or exercise price) is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price (market price) of the underlying instrument at that time.
Formally, the strike price can be defined as the fixed price at which the owner of an option can purchase (in the case of a call), or sell (in the case of a put), the underlying security or commodity.
For example, an IBM May 50 Call has a strike price of $50 a share. When the option is exercised the owner of the option will buy 100 shares of IBM stock for $50 per share.
A call option is said to be in-the-money if the stock price is trading above the strike price. A put option is in-the-money if the strike price is higher than the market price of the underlying stock. A call or put option is at-the-money if the stock price and the exercise price are the same (or close). A call option is said to be out-of-the-money if the stock price is lower than the exercise price of the option. A put option is out-of-the money if the stock price is higher than the exercise price of the option.
For an option contract, expiration is the date on which the contract expires. The option holder must elect to exercise the option or allow it to expire worthless.
Typically, option contracts expire according to a pre-determined calendar. For instance, for U.S. exchange-listed equity option contracts, the expiration date is always on the Saturday that follows the third Friday of the month, unless that Friday is a market holiday, in which case the expiration is on the Friday.
In the case where the option is not exercised, upon expiration any margin charged by the clearing firm to the holder or writer of the option is released. The margin may then be used for any purpose, for instance to finance subsequent option trades.
Open interest↑ Top
Open interest refers to the total number of derivative contracts, like futures and options, that have not been settled in the immediately previous time period for a specific underlying security. A large open interest indicates more activity and liquidity for the contract.
For each buyer of an options contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered ‘open’.
Use of Open Interest in Technical Analysis
Many technical analysts believe that a knowledge of open interest can prove useful toward the end of major market moves. For some option traders, open interest indicates the intensity of trading in a financial instrument. If open interest increases suddenly, it is likely that new information about the underlying security has been revealed, which may indicate a near-term rise in the underlying security’s volatility. However, neither an increase in volatility nor open interest necessarily indicate anything about the direction of future price movements.
A leveling off of open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market. Technical analysts view increasing open interest as an indication that new money is flowing into the marketplace. From this assumption, one could conclude that the present trend will continue. Analogously, declining open interest implies that the market is liquidating, and suggests that the prevailing price trend is coming to an end. However, a change in open interest indicates a difference in the number of buyers and sellers of an option. Like volatility, it has no directional component, it is just a tally of unsettled contracts.
The Importance of Open Interest
Open interest is a concept that all option traders need to understand. Although it is always one of the data fields on most option quote displays—along with bid price, ask price, volume, and implied volatility—many traders ignore open interest. But while it may be less important than the option’s price, or even current volume, open interest provides useful information that should be considered when entering an option position. First, let’s look at exactly what open interest represents. Unlike stock trading, in which there is a fixed number of shares to be traded, option trading can involve the creation of a new option contract when a trade is placed. Open interest will tell you the total number of option contracts that are currently open—in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment.
The owner of an option contract may exercise it, indicating that the financial transaction specified by the contract is to be enacted immediately between the two parties, and the contract itself is terminated. When exercising a call, the owner of the option purchases the underlying shares at the strike price from the option seller, while for a put, the owner of the option sells the underlying to the option seller.
The option style determines when, how, and under what circumstances, the option holder may exercise. It also lets the trader chose whether he wants in or out
- European – European-style option contracts may only be exercised at the option’s expiration date. These contracts
- may not undergo early exercise, and therefore can never be worth more than an American-style option of the
- same strike price and expiration date.
- American – American-style option contracts can be exercised at any time up to the option’s expiration. Under
- certain circumstances (see below) early exercise may be advantageous to the option holder.
At exercise, the option contract specifies the manner in which the contract is to be settled.
- Physical settlement – Physically settled options require the actual delivery of the underlying security. Examples of physically settled contracts include U.S.-listed exchange-traded equity options.
- Cash settlement – Cash-settled options do not require the actual delivery of the underlier. Instead, the corresponding cash value of the underlier is netted against the strike amount and the difference is paid to the owner of the option. Examples of cash-settled contracts include most U.S.-listed exchange-traded index options.
Assignment and Clearing
Assignment occurs when an option holder exercises his option by notifying his broker, who then notifies the Options Clearing Corporation (OCC). The OCC fulfills the contract, then selects, randomly, a member firm who was short the same option contract. The OCC then notifies the firm. The firm then carries out its obligation, and then selects a customer, either randomly, first-in, first-out, or some other equitable method who was short the option, for assignment. That customer is assigned the exercise requiring him to fulfill the obligation that he agreed to when he wrote the option.