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WIKI ANALYSIS
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This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it. |
This is an introduction to Options Trading. This page focuses on plain-vanilla options, (puts and calls) and should serve as a general overview of how options are constructed, options terminology and how options payoff.
Other articles in the Guide to Options investing include:
What is an Option?
Options can be confusing because they add another level of complexity to investing. They also have a unique terminology that must be mastered to understand what a particular option contract represents. Perhaps the most common misunderstanding for those new to options, is the idea that no shares of the underlying security change hands when an option is written or purchased; an option is nothing more than a contract between two parties.
Options are a type of financial security, just like stocks, bonds and mutual funds, and can be bought and sold just as easily as one buys and sells stocks. 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). Generally, options are used as a tool to make more leveraged investments in common securities. Because they are less expensive than the underlying asset, relative percent return that can be achieved through options is significantly higher than on the underlying asset alone. The graph below shows just that.
With the advent of low commission online brokers offering options, it is becoming easier to invest in options. This is a good thing for retail investors as it allows them to take advantage of the two main benefits of trading options: versatility to respond to any market situation and leverage. It is also a potentially dangerous situation since options, especially individual options, do entail risk and this risk is magnified when investors do not know how to invest in options appropriately. The purpose of this guide is to educate investors on how options are priced and how to use options to augment one's current investment goals.
Types of Options
Calls and Puts
Calls and puts are the two types of "plain vanilla" options, and most advanced option positions are constructed using a combination of calls and puts. Other options, known as exotic options, are gfnfgngfnhis or her option.
American vs European
There are also two types of standard put and call options, known as American options and European options. The difference between the two has nothing to do with physical geography, but rather how and when the options can be exercised. American options can be exercised anytime before the option contract expires, while European options can only be exercised on the expiration date. Options traded publicly on exchanges are nearly always American options, while options that are traded over the counter are mainly European options.
Components of an Option Contract
- A Buyer and a Seller: The seller, or writer, of the option is obligated to sell 100 shares of the underlying security should the buyer decide to execute the option. If the buyer chooses not to execute their option, neither party holds any further obligation.
- Call buyers are bullish on the underlying security and owning a call is equivalent to having a long position in the underlying. Call sellers are neutral or bearish on the underlying security and look to profit by taking in premium from call buyers.
- Put buyers are bearish on the underlying security and owning a put is similar to shorting the underlying. Put sellers are neutral or bullish on the underlying security and again look to profit from the option premium.
- An Underlying Asset: All options require some other asset, whose price determines the payoff of the option. Options are most commonly written on shares of stock, but they can also be made for bonds and other types of securities. An option's value and payoff is directly related to the price and volatility of an underlying asset.
- Strike Price: The strike price is the agreed price at which an option buyer can buy (in the case of a call option) or sell (in the case of a put option) the underlying security. For plain-vanilla options the strike price is a fixed part of the option contract and does not change during the life of the option. When an option is exercised, meaning the underlying security is either bought or sold by the option buyer, it is exercised at the strike price.
- Expiration Date: Options are bought or sold for a given time period and therefore have an expiration date. After this date, the option buyer loses his right to buy or sell the stock and the option seller is released from their obligation. For options on stocks, the last day of trading is the third Friday of the month and the options expire on the third Saturday. For example, if one bought July '08 call options on IBM, the last day of trading for those options would be July 18, 2008 and they would expire July 19, 2008
Option Payoffs
For standard put and call options the payoff to the option holder is relatively simple. Note that when talking about option payoffs it is convention to ignore the price of the option and consider only the amount of money the holder gets for holding the contract to maturity.
Call Options
The holder of a call option will only execute the option if, on maturity, the current price of the underlying asset is greater than the strike price. If this is the case, the call holder can purchase shares at the strike price and sell shares at the market price, netting the difference as profit. In the case that the strike price is greater than the price of the underlying asset at the time of maturity, the call option is worthless - the holder would prefer to purchase the asset at the current market price and thus would not exercise the option. The payoff of a plain-vanilla call option at maturity is,
where CT represents the value of the call at maturity time, T, K represents the strike price and ST is the price of the underlying stock at time T. The graph below shows the relationship between the payoff of a call option and the price of the underlying security at maturity.
Put Options
The holder of a put option has the right (but not the obligation) to sell shares of the underlying asset at the strike price upon maturity. As such, it is only profitable for the holder to do so if they can sell the shares when the strike price is greater than the market price at maturity. The value of a put option at maturity is,
where PT is the value of the put option at time T, K is the strike price and ST is the price of the underlying asset upon maturity. The graph below shows the relationship between the payoff of a call option and the price of the underlying security at maturity.
Option Pricing
The price of a particular option contract consists of intrinsic value and time value.
- Intrinsic value for a call option is the price of the underlying security minus the strike price.
- As put options are the opposite of call options, intrinsic value of a put option is the strike price minus the price of the underlying.
- Time value is the amount of the option premium that can be attributed to the time remaining until expiration and is simply the option premium minus the intrinsic value.
- Option premiums are determined using complex mathematical equations that take into account price of the underlying security, strike price, time to expiration and most importantly volatility of the underlying security. See the Option pricing page for more.
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