Basics - What is an Option?
Suppose you agree to sell something. And suppose you and the other party has agreed on a price and a time to complete the sale. In such a case, you have what is called, in the realm of finance, a forward contract.
However, if you agree to let someone have the privilege of buying something from you at a stated price and for a limited time, if and when the other party decides to do so, you have sold an option.
The holder of the option possesses the right, but not an obligation, to buy something at a stated price for a limited time. The party who sold the option is obligated to deliver the goods if the options holder decides to exercise his option.
The asset that would be delivered is called the ‘underlying asset”, or just “the underlying”. The price agreed to is called the “strike price” or “exercise price” of the option.
For example, let’s say I have a piece of real estate worth $100,000. I could agree to let someone have an option to buy the property from me for, say, exactly $100,000 at any time during the next two years. The option’s strike price is therefore $100,000, the underlying is the property itself, and the expiration date is two years from today.
Now, why would I enter into such an agreement? After all, if the property increases in value over the next two years, that appreciation would be lost to me because I have agreed to sell the property for $100,000. Furthermore, I am locked into owning the property, and may not sell it to anyone for the next two years – because if the option holder decides to exercise, I am obligated to deliver the property. So why should I put myself in such a constrained position?
First, for the money I receive. An option has value, and won’t be granted without compensation. I may need to receive, for example, $15,000 for this particular option. The $15,000 (should the option buyer agree to that amount) would be mine to keep, regardless of the outcome (whether or not the buyer decides to exercise his option). The price paid for an option is usually referred to as the “premium”.
The second reason for me to do this is that I may be unwilling, or unable, to sell the property at this time. Under those circumstances, I might be happy to at least receive $15,000 immediately, especially if I do not believe that the house is likely to appreciate more than $15,000 over the next two years.
What happens at the end of the two year period, as we approach the expiration date of the option? If it turns out that the property appreciates less than $15,000, then I’m better off for having sold the option. If the property appreciates exactly $15,000 during the next two years, I end up with the same outcome as if I had not sold the option. And if the property appreciates more than $15,000, then I may regret having sold the option.
Why might someone want to buy an option? For one thing, leverage. In this example, for just $15,000 an option buyer can have control over a $100,000 asset. Without incurring the hassle of ownership, he has the right to own the property any time simply by submitting an exercise notice and paying the agreed $100,000. Suppose, during the next two years, he pursues his plans for the property, and those plans don’t come together the way he hoped. He now has greater flexibility in getting out because, in fact, he never got in; he never bought the property. He can simply let his option expire.
Also, the option buyer may believe that the property will appreciate more than $15,000 during the next two years. If it does, he could exercise his option and then sell the property for more than $115,000.
Another reason to buy an option, rather than the asset itself, is the limited risk. Although real estate doesn’t often drop in price, if the value of this property, for whatever reason, were to fall below $100,000, the option holder is not likely to exercise. Why should he pay $100,000 for something that could be bought, on the open market, for less than $100,000? And if the value of the property were to fall to less than $85,000, the option buyer would be happy that his loss is limited to the $15,000 he paid for the option, rather than having bought the property and now seeing a loss of more than $15,000.
Does the strike price of an option have to be precisely equal to the property’s current fair value? Of course not. I could have written (sold) my option at a strike price of, say $110,000 -- $10,000 above the current fair value. Such an option wouldn’t be worth as much, however, and I probably would not get $15,000 for it. When an option’s strike price is above the underlying’s current market value, the option is said to be “out of the money”. (More on this later. As we will see, I might prefer selling an out-of-the-money option because it gives my asset room to appreciate.)
Does this option have to end either in exercise or by letting it expire? No, there is a third possible outcome. If the two parties are willing and can agree on a price, the option seller may buy back his option, effectively canceling it out.
Again, to open an option position the buyer (holder) pays the seller (writer) an agreed amount (premium) for the option. This premium is the writer’s to keep, regardless of the outcome.
The following table summarizes the possible closing option transactions.
If the option holder
The option writer
Pays for the asset.
Receives the asset.
Receives payment for the asset.
Must deliver the asset.
If the option writer agrees, sells his option back.
Buys the option back, effectively canceling the position and eliminating any further obligation.
Does nothing, allowing his option to expire.
Gets to keep his asset.
No additional cash changes hands.
In the example above, an option was transacted between two individuals. Its strike price and duration were created by agreement between the two parties to meet their specific needs. Its price was also reached by negotiation. The underlying asset was a specific and unique piece of property. Options that are tailored to a specific situation, with the terms negotiated, are often called over-the-counter (OTC) options. As you can imagine, this process is cumbersome, and finding a willing counter-party usually involves a third party. That’s why these types of options are done primarily by large institutions.
In contrast, individuals are more likely to trade “listed” options. These are standardized contracts traded on exchanges and are available on many stocks, indexes, bond futures, commodity futures, and currency futures. There are even options on interest rates, inflation rates, and the weather.
With listed options, you do not need to worry about the trustworthiness of the other party to the transaction. A single clearing agency, such as the Options Clearing Corporation, stands in the middle of every trade, guaranteeing the transaction to both the buyer and the seller.
If an option holder exercises his option, the clearing corporation assigns any party holding a short position on a random, arbitrary basis. An option buyer never finds out, nor does he care, who sold the option to him. An option seller never finds out, nor does he care, who bought the option from him.
Listed options have many attractive features. For one thing, several strike prices are usually available at regular price intervals. Also, several different durations (expiration dates) are usually available, following a set pattern. In stocks, for example, one set of options expires in 30 days or less, another set of options expires in approximately 31 – 60 days, another set expires in approximately 3 – 6 months, and so on, going out as far as 2 years or more.
Each listed option is standardized for the same quantity of the underlying asset. In the U.S., for example, one stock option is based on 100 shares of an underlying stock, and one futures option is based on one futures contract. By standardizing options contracts, the exchanges make them appealing to large groups of investors, which results in heavy trading and a liquid market.
As the markets are constantly moving, options prices are continuously quoted and changing. Market makers at the options exchanges are always publicly posting prices at which they are willing to buy and sell each option. They stand ready to take the other side of your trade, and thus “make a market” in the options they are responsible for. This allows an option holder to sell his option(s) at any time, and an option writer may buy to close his position at any time.
In the real estate example discussed previously it is very possible, even likely, that the option holder will exercise his option prior to expiration. In contrast, the vast majority of listed option buyers never exercise them; they simply sell them back on the open market. Many of these people are speculators who only expect to hold their option for a short time. Once the underlying makes a move in the expected direction (or perhaps a move in the wrong direction) they sell. In a sense, options are like hot potatoes being tossed around among speculators. This accounts for quite a bit of the options trading volume.
Another big source of trading volume is institutional trading. Institutions may use options to hedge large positions, or simply trade large positions for speculation.
So far we have only talked about options to buy. Options to buy something at a stated price for a limited time are call options. There is another type of option – an option to sell something. While these options can be a bit more difficult to conceptualize, options to sell something at a stated price for a limited time are put options.