Introduction to Options #2

What is an option?


As a recap, it’s worth understanding what is an option:

“An option provides the option-holder with the right, but not an obligation, to buy or sell a certain asset (generally, a number of shares in a company) for a certain price up until an expiry date.


All options share common features, allowing traders to freely trade them on exchanges without inspecting the contract. If there were variances, it would be a taxing exercise to review every detail before trading. Here we take a closer look at the fundamental components of an option in more detail.


Option type


There are two main types of options:

  • Call options afford a holder the right to buy the underlying asset

  • Put options afford a holder the right to sell the underlying asset

You buy a call if you expect the underlying asset price to appreciate, and a put when expecting a fall.


Underlying asset


An option is the instrument through which you can acquire the right to buy or sell an asset. That asset is is the one underlying the option. Although the underlying asset is most commonly thought of as shares in a company (e.g. 1000 shares), it is not restricted to equities.


In fact, the underlying asset can be ETFs, indices, commodities and more. With indices, you gain exposure to a wide variety of stocks through the one financial instrument, as well as the effects of broader macroeconomic events on the market.


As another example, picture commodities like oil. Few, if any traders would want to physically own oil. While it is a tangible asset, it does not offer the same accessibility, liquidity or leverage as its virtual counterpart. Therefore, options provide exposure to the commodity’s price movements, while not committing a trader to purchase or sell the commodity.


Expiry


Every option has an expiry date. There is a finite period in which it offers potential benefit. This date is the last chance to trade or exercise the option, otherwise it expires and becomes worthless.


Shares do not have a life cycle. There is nothing preventing you holding the stock indefinitely, failing its collapse. For the option to hold value, the asset must conform with your price expectations.


Option expiry often follows a quarterly life cycle, with availability shown for the current quarter, plus the two thereafter. With that said, expiry can also span from shorter terms (spot), to longer periods (years). As for the specific date, this will be notated in the instrument contract. For indices it is generally the third Thursday of the month, while for stocks it is the Thursday before the last working Friday of the month.


Exercise price


Also called the strike price, this is the fixed price per unit you will pay or receive for the underlying asset if the option is exercised. The market establishes the exercise price based on supply and demand. There will generally be one contract with an exercise price near the prevailing asset price, plus others set above and below.


Option premium


This is the market price of the option, determined by supply and demand - bids to buy, and orders to sell. It is not set by the exchange administrator, unlike other aspects of an option contract.


The contract cost may be thought of as its size (often 1000 shares) multiplied by the option premium. Do not confuse the premium with the exercise price. The former is what you have paid to acquire a right over an asset, whereas the latter is the price to acquire said asset.


Exercise style


Options may be exercised under two methods, either American (exercise before or at expiry), or European (exercise only at expiry). Settlement of a call may be deliverable (you receive underlying shares), or conversion of the asset into cash.


Put options


Much of the above focus has been on call options, but let’s consider an example of a put.


Consider: ABC July $5.50 Put Option @ $0.20


This option provides the option-holder the right to sell ABC shares for $5.50 each, up until the expiry date in July. To acquire this option, there is a premium of $0.20 per option.


Although the features are the same as a call, exercising the put results in a different settlement. In this instance, you would receive the exercise price when delivering the underlying shares you own. A put is beneficial when you have a bearish outlook.


So why hold a put if you also need to own the underlying asset? The put locks in a sale price, regardless of what price action follows. Thus, it protects the underlying asset. It also offers leverage to a falling price since the option will appreciate in value. With the greater percentage movements, that can mean larger profits, but the risk of losses exists if the underlying asset increases in price.


Options contract adjustments


By now you may be wondering, what happens to options when corporate events affect the structure and price of the underlying asset. Provided holders are affected based on their holding size, the exchange administrator will adjust the option contract terms. Events might include:

  • Rights issues

  • Share splits or consolidations

  • Bonus issues

  • Special dividends

  • Cash returns of capital

Consider: ABC; 10 million shares; $20 market price; 1:1 bonus issue

In the above example, shares on issue will double to 20 million under a 1:1 bonus issue. However, the company’s value will remain stable, it is the share price which halves to $10 per share. An adjustment is necessary. The likely outcome would be for the exercise price to align closer to the revised market price, seeing as the number of contracts and size of your rights to the underlying asset will have doubled.


Summary


  • An exchange administrator sets and adjusts option contract terms, except for the option premium, which is decided by market participants

  • There are standardized, fundamental components of an option

  • Put and call options are similar, except for the rights attached, plus settlement and deliverance

  • Puts are useful to leverage falling prices and lock in a minimum sell price for an asset you own

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