The simplest type of option is the European Call Option which gives the holder the right to buy something in the future at a previously agreed price with no obligation.
For example you can have a call option on an underlying stock.
If the price of the stock goes up then you can potentially buy the stock at a cheaper price that the current market price.
If the price of the stock goes down then you don't have to buy the stock.
Put Option -
Over the Counter
Different Types of Options
Calls and Puts are the simplest types of options and are often referred to as Vanilla Options.
There are also two different types of options based on when they can be exercised.
European Options - A European option can only be exercised at maturity and not before.
American Options - An American option can be exercised at any point prior to expiry.
The underlying asset which the option is based on can be almost anything.
The common assets are stocks, commodities, currencies and indices.
The first exchange traded options were in 1973.
Chicago Board Options Exchange (CBOE)
These exchanges make it simpler and more efficient to match buyers and sellers
Part of the simplification involves the conventions about such features of the contracts as the available strike prices and expiries
For example simple call and puts come in series
This refers to the strike and expiry dates.
Typically a stock has three choices of expiries trading at any time.
Having standardised contracts traded through an exchange promotes liquidity of the instruments.
Long Term Equity Anticipation Securities are longer dated exchange traded calls and puts
They started trading in the late 1980s.
They are standardised to that they expire in January each year and are available with expires up to three years.
They come with 3 strikes, corresponding to at the money, 20% in and 20% out of the money with respect to the underlying when they are issued.
In 1993 the CBOE create FLEX (FLexible EXchange) traded options on several indices
These allow a degree of customisation in the expiry date (up to 5 years), the strike price and the exercide style
Over The Counter
Not all options are traded on exchanges.
Some options are sold privately otherwise known as OTC from one counterparty to another.
A term sheet specifies the exact details of an OTC contract.
The payoff that would be received if the underlying is at its current level when the option expires
An option with positive intrinsic value is said to be in the money
Any value that the option has above its intrinsic value.
The uncertainty surrounding the future value of the underlying asset means that the option value is generally different from the intrinsic value.
An option with only time value (no intrinsic value) is said to be out of the money
lookbacks, asians, parisians, cliquets, embedded decisions
If you are short in the market - buy call to limit losses
If you are long in the market - buy put to limit losses
In the money call option - short stock
a) if the stock goes down the short is covered
b) if it goes up you call the option to settle at a profit
(hedging against translation risk)
Options are more flexible and advantageous than buying forwards and naturally cost more. The cost is the premium and is usually paid in advance. The option protects against a detoriation in the rate but the option buyer can still benefit from an improvement in the rate.
There are very few exchange traded options contracts (standard size, set expiry) in the Europe. This is largely due to the strength of the OTC market.
The advantage of standard contracts is that there is plenty of competetion
The exchange protects contracts from default by the use of a Clearing House
There are exchanges for traded options and futures but these products can also be purchased OTC
The advantage of a trading exchange is that there is plenty of trading liquidity, there are competing traders to ensure good prices and there is the implicit protection against default provided by the body called the Clearing House.
You can often trade the instrument back to the exchange.
The disadvantage is that the products are standardised and may not suit the users exact requirements.
Traded options are standardised options which grant the buyer the right (but not the obligation) to buy or sell an instrument at standard prices and dates in the future. A premium is charged for this right and is paid when the option is bought.
There are 4 possibilities
Maximum Loss Maximum Gain
Buyers of options Premium Unlimited
Writers of options Unlimited Premium
On the trading exchange, there is a further choice of "trading the option" ???
Trading the Option
there is a choice of share prices at which calls/puts can be bought/written. they are called exercise or strike price
There is a choice of dates for expiry of the contract, 2 dates are offered to a maximum of 9 months ahead.
- The options must be dealt in multiples of 1000 shares
(that is standardised contract sizes)
options can be traded that is sold back to The market for a later permium
Having bought an Option it can be exercised at Any time prior to The expiry date. This is an American option. Most options on European exchanges are American.
Intrinsic Value - this occurs when the call exercise price is cheaper that the market price
or when a put exercide price is dearer than the market price
(you can only have a positive intrinsic value)
Time Value in the option - Steadliy decreasing regardless of price
Calculating the premium - The Black Scholes formula with one of two possible modifications, is still widely used to calculate the necessary premiums.
Implied Volatility -
Historic Volatility -
Lets assume we buy a call option with an exercise price of £1.80 and the premium is quoted at 24.
If we exercise the option we buy 1000 shares at £1.80 and sell them at the market price of £2.06 making 26p ignoring dealing costs.
As the option cost is 24p per share our profit is 2p a share.
27 March (buy the call option)
Market Price - 186
Intrinsic (6) + Time Value (18) = Premium (24)
Market Price = 206
Intrinsic (26) + Time Value (10) = Premium (36)
If instead we decide to trade the option we would sell it back for 36p (ie todays premium)
As the option cost was 24p our profit would be 12p
In the first example we make a profit of £20.
In the second example we make a profit of £120
When we exercise we recieve the intrinsic value (26)
When we trade we receive the intrinsic value and time value (36)
The actual standard exercise price is rarely exactly the same as ther market price.
As a result it is very common to call the "at-the-money" option the one which is nearest to the market price
Options on indices - you can also get options on a whole index
We can see that the idea has advantages.
We can back a view on the whole market and not just an individual share.
Breakforward Option -
Interest rate options are settled on the basis of a value per 0.01% change in the interest rate.
If you want to gain from higher interest rates buy put options - the contract price will fall
If you want to gain from lower interest rates buy call options - the contract price will raise
Buying an option protects against a deterioration in the rate but the option buyer can still benefit from an improvment in the rate.
American Options - these are the most common in the UK
Options - Theses are highly-geared investments a comparatively small movement in the underlying results in a proportionately mauch large movement in the value of the option.
Writing Naked Options
Selling options when you do not have an existing position to hedge is the most dangerous strategy
Unless you are a very large financial institution with very deep pockets you wouldn't write naked options.
If you are bullish - you are buying a call option
If you are bearish - you are buying a put option
A traded option differs from the traditional type in that you can buy and sell the option itself much as if were stock.
An option to buy a share at 105p when the share price is 105p is "at the money" (exercise price = market price)
An option to buy a share at 105p when the share price is 100p is "out of the money" (exercise price < market price)
An option to buy a share at 105p when the share price is 100p is "in the money" (exercise price > market price)
Put options work the other way round
The time value in an option erodes throughout its life. It may be worth paying 10p for a chance that a share price will rise by the required amount sometime in the next 3 months
It would probably not be worth paying the same price if the option only had a week to run.
The market price of an option will usually drop gradually with the passage of time unless the market price of the underlying moves in the right direction (up for call options, down for put options).
Things to Remember
An option with a strike price that is close to the current price is said to be at the money.
The first put was created and traded in 1977.