CommonLounge Archive

January 30, 2018

Options are contracts that give their holder the right (or the privilege) to execute a transaction in the future at a predetermined price within a specific period of time (before the expiry date).

Options are considered derivative contracts since their price is linked to the price of an underlying security1 and its potential fluctuations. Options can be bought (or sold) on commodities, forex pairs, as well as stocks.

The predetermined price of the security at which the option holder can buy or sell it is called the strike price.

1A security is a financial instrument that has a monetary value, and it can be bought or sold in the financial markets. Examples of securities include forex pairs, company shares (equities), and bonds.

Types of Options

An investor may believe that the price of a stock that she has may decline in the future, and instead of selling the stock now she wants to protect herself against that decline. Let’s say that the current price of the stock is at $100, and the investor is concerned that the price will decline to$80 or even lower, therefore she purchases the option to sell the stocks at any time within the next three months at a price of $95. In this case, the investor has purchased **a put option**. So even if the price of the stock declines to$60 she will still be able to sell it at $95 and make a minor loss. Call Option On the other hand, an investor may want to purchase a certain asset only if certain conditions are met in the future. For example, let’s assume an investor expects a government regulation to get enacted in the future, which would both give more subsidies to companies that work in the sector of renewable energies and buy energy from them. The investor has the expectation but is unsure about whether this regulation will pass or not. If the government decides on granting the subsidies and buying the energy output, the price of shares of the supported companies will likely rise. Let’s assume that the price of the share is$200 today, but if the regulation passes the price may rise to even$400 or higher. The investor, in this case, may choose to buy a call option to buy the share at$250, within a period of one year. Typically, the investor will only choose to exercise his right to buy the shares at$250 if the price of the stock goes well above$250 enough to cover the cost of the option. Otherwise, if the regulation does not pass and the price of the stock remains at$200, then the investor is not likely to exercise his right and the option will expire. In short, a put option is a right to sell a security whereas a call option is a right to buy a security, and both are concerned with the future price of the underlying security, and the right given can be exercised only before the expiry date. Options Cost The cost of buying an option is often called a premium. The buyer of the option cannot recover the cost of the option even if he does not exercise the right given to him by the option within the allowed period. Therefore, the cost of the option can be considered a sunk cost (irretrievable cost). The option premium may rise or decline depending on the prevailing market sentiment regarding whether the price of the underlying security will decline or rise. For example, if the prevailing sentiment is that the price of soy beans will rise, then the call premium will increase, whereas if the overall sentiment is that the price of soy beans will decrease, then the put premium will increase. Long Positions and Short Positions Before explaining the positions of participants in the options markets, we need to explain briefly what long and short positions mean. If an investor expects the price of a security to rise and buys it, he is said to have entered a long position. Investors usually enter long positions when they expect the asset to appreciate in value. On the other hand, if an investor expects the price of a security to decline and sells it, he is said to have entered a short position. Investors usually enter short positions when they expect the asset to depreciate in value. The Buyers (Holders) and the Sellers (Writers) of the Option As with any other transaction, options involve buyers and sellers. If an investor chooses to buy a call option, then he is considered a buyer or a holder of the option. In this case, he will be expecting the price to rise, therefore, he will be in a long position. The seller of the same option is called a writer of the option, and he expects the market to go down, therefore he is in a short position. Similarly, if the investor expects the value of an asset to drop, and he buys a put option, then he is entering a short position. The seller of this put option is entering a long position. Difference Between an Option and a Forward Contract Forward contracts are contracts that entail an agreement between a buyer and a seller to carry out a transaction at a certain point in time in the future at a predetermined price. While an option gives its holder the right, but not the obligation, to purchase (or sell) an asset within a specific period of time at a determined price, forward contracts are different in that the buyer in forward contracts is obligated to carry out the transaction. Investment Strategies using Options Different Investors have different motivations when they buy options. To keep things simple, their motivation can be either one of two: maximizing their gain or minimizing their losses (sometimes it is both at the same time). Investors can maximize their gains by choosing to buy call options at mildly high prices when in fact they expect the price to soar. If the price soars in the future and they have the call option, they can quickly exercise their right and buy the share at a lower price than the actual price (in the future), and then sell it at the actual price and make a profit. They can also minimize their losses if they expect the price of an asset to drop significantly and they buy put options at a very mildly lower price. Then if the price drops significantly in the future the investor can exercise his right and sell the share at a higher price than the actual price (in the future). Another interesting use of options is gauging the sentiment of the market. Market participants can use the ratio of put/call open interest to see where investors are placing their bets more heavily. After knowing the sentiment, investors can make better-informed decisions regarding investment in the actual market (not in the options market) Open interest refers to the number of outstanding options not yet carried out in the forwards or options market. Other types of options The mentioned options can be applied when you do not already have open positions. However, when you have open positions, you can choose one of two options. 1. Buy to close: this option can be used when you have an open short positions, which you can closed using this option to stop the exposure. 2. Sell to close: this option can be used to sell an asset you already hold. In other words, it is used to stop a long exposure. Options Table The options table reveals the information related to the available put and call options. The information includes the followings: • The strike price: the future price at which the security will be sold or bought • Change: the difference between current and previous price • The percentage change: the percentage change in current price from the last price • Bid: the price at which buyers are willing to buy the option • Ask: the price at which sellers are trying to sell the option • The volume: the number of transactions (trades) carried out • Open interest: the number of options not yet bought or sold Below is an example of an options table for Apple shares. It shows the most active put and call options. Notice how the open interest differs at each price, and also the open interest for calls at$172.50 is 28179, which is higher than the open interest for puts at$170 which is 20169. This may reflect a mild bias to the upside. Also, you can notice the variance in the prices between puts and calls. The bid and ask prices for calls at at 175$are higher (at a premium) than at\$170, also reflecting heightened possibility of increase in price.

Options Table for Apple Shares