What Are Options?

Introduction:


Options are one of the three main derivative types (the other two being futures/forwards and swaps) traded on global exchanges. They are effectively contracts that represent the right to buy or sell an asset (stocks, bonds, foreign currencies, etc) at a certain price.



Technical Terms:


Before we go any further, you need to have a vague idea of what the jargon behind options actually means, so I have made a list of the key terms and their definitions below:


Premium: The amount in currency paid for the contract.


Strike Price: The financial value at which the underlying financial asset can be purchased or sold for.


Expiration Date: The date on which the option contract can be either used or becomes worthless.


Intrinsic Value: The payoff received if the option expired at the current price of the underlying asset.


Time Value: Added value given or taken away from the option due to the value of time (more time gives you more options).


In The Money: An option with a positive intrinsic value


At The Money: An option with a strike price close to the current underlying asset level.


Out of the Money: An option with no intrinsic value, but with time value.



American/European/Bermudan Options:


This has nothing to do with where the options are either listed or traded - a common mistake!


European options can only be exercised at the expiry date, while American options can be used any time before the expiry date.


Bermudan options are effectively in-between American and European options and can be exercised on specific dates/in specific periods.


Types of Option:


Put: This gives the holder of the option the right to sell an underlying asset at a certain price.


Call: This gives the holder of the option the right to buy an underlying asset at a certain price.



The easy way to remember what "put" and "call" mean is to think about it in the context of "putting something away" (getting rid of something) and "calling something towards you" (bringing something closer to you).



Binary/Digital: These are very similar to standard put and call options, but in this context you are either right or wrong on the move in the underlying asset (as standard, they never pay off more than $1).


These are best to use if you believe that the option will finish marginally in the money. If you believe that there's going to be a very large move in the underlying asset, then it is better to pick a standard call over a binary call, because the return you can gain grows linearly at prices above the strike price - you'll make more money.



Convertible Bonds: These work in a very similar manner to bonds, in that they can either pay a stream of coupons or be turned into underlying stock in an asset (prior to the expiration date).


Warrants: Warrants usually have longer lifespans than options and tend to act in the style of American options. They also involve the issuing of new stock at the agreed strike price (rather than the purchasing of existing stock).


LEAPS/FLEX: LEAPS (Long-Term Equity Anticipation Securities) are longer dated calls and puts traded on exchanges with standardised expiration dates in January each year. Time to maturity can last up to three years. These have three strike prices at 20% levels in and out of the money relative to the underlying asset.


FLEX (Flexible Exchange-Traded Options) were listed on the Chicago Options Board Exchange (CBOE) in 1993 and are basically LEAPS with a higher level of customisation in regards to the expiry date and the strike price.


OTC Options: These are simply options not traded on a major exchange (e.g. CBOE), sold between private bodies. These will often carry different rules regarding the payment of premium and are open to a very high level of customisation.



Why trade options?


There are a few reasons why people may decide to trade options, but generally the two main reasons are to either use them to hedge an existing portfolio or alternatively as an instrument of speculation.


To understand why someone may trade an option rather than the underlying asset comes down to something called "gearing". Generally, the term "gearing" is used synonymously with "leverage", which isn't wholly true in the case of options markets:


A Crude Gearing Example:


Let us pretend that The Masked Trader Inc. is trading at $100.

The cost of a $102 call option is $20


There are two ways of potentially profiting here:


1. Buy the underlying stock:


Let us say that the stock rises to $200.

In this case you would make a profit of $100 or 100%.


2. Buy the call option:


If I buy the call option for $20, then at expiry (assuming a European option) I can use this, paying $102 for an asset worth $200. I have paid $20 per option and get back $98. This is a profit of $78 per option, but in percentage terms this amounts to:


value of asset at expiry - strike - cost of call *100
                           cost of call


= 200-102-20   *100
           20             


=390%



That was a rather crude example, but you can see that in percentage terms it makes more sense to purchase the option than it does to purchase the underlying asset in regards to capital growth.