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An option contract stipulates that one party (the holder or buyer) has the right (but not the obligation) to exercise the contract (the option) on or before a future date (the exercise date or expiration) and the other party (the writer or seller) has the obligation to honor the terms of the contract. Since the option gives the buyer a right and the writer an obligation, the buyer pays the option premium, which is the cost of the option, to the writer.
Because this is a contract whose value is determined by an underlying security, it is classified as a derivative. Put options give the holder the right to sell the asset for a specified price, called the strike price. Call options give the holder the right to purchase the asset for a specified price.
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The contract specifies
the strike price or exercise price. It can be specified, or based on a reference rate, or measured at agreed-upon intervals during the life of the contract.
the quantity of the security included in each contract. This is standard and predetermined by the exchanges for traded options, e.g. common share options have 100 shares in 1 contract.
the ratio of actual settlement price to the price quoted in the market, also known as the 'multiplier'.
Example: a call option on 100 shares (one contract) of (NY-JNJ) at strike price $54.00 to expire Dec2007 with a multiplier of 100. 1 JNJ Dec Call $54
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Option frameworks
The buyer pays the price (premium) to the seller (writer). He assumes a long position, and the writer a corresponding short position. Thus the writer of a call option, is "short a call" and has the obligation to sell to the holder, who is "long of a call option" and who has the right to buy. The writer of a put option is "on the short side of the position", and has the obligation to buy from the taker of the put option, who is "long a put". See the basic option trades below.
The option style determines when the buyer may exercise the option. It will affect the valuation. Generally the contract will either be American style - which allows exercise up to the expiration date - or European style - where exercise is only allowed on the expiration date - or Bermudan style - where exercise is allowed on several, specific dates up to the expiration date. European contracts are easier to value. Due to the "American" style option having the advantage of an early exercise day (i.e. at any time on or before the options expiry date), they are always at least as valuable as the "European" style option (only exercisable at the expiration date).
Options can be in-the-money, at-the-money or out-of-the-money. The "in-the-money" option has a positive intrinsic value, options in "at-the-money" or "out-of-the-money" have an intrinsic value of zero. Additional to the intrinsic value an option has a time value, which decreases the closer the option is to its expiration date. The option premium is equal to the intrinsic value plus the time value.
Buyers and sellers of exchange-traded options do not usually interact directly - the futures and options exchange acts as intermediary. The seller guarantees the exchange that he can fulfill his obligation if the buyer chooses to execute.
The risk for the option holder is limited: he cannot lose more than the premium paid as he can "abandon the option". His potential gain with a call option is theoretically unlimited; see strike price.
The maximum loss for the writer of a put option is equal to the strike price, minus the premium received. The risk for the writer of a uncovered call option is unlimited. However, a call writer who owns the underlying instrument can always meet his obligations by delivering the asset he owns; if the writer does not own the asset, then it is a naked call, or uncovered call. A covered put is one where the writer has the cash equal to the strike price; otherwise, it is a naked put.
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Option naming conventions
Stock option names are written in the following format: SYMBOL+MONTH+STRIKE
SYMBOL = Option Root Symbol
MONTH = Month the option expires
Expiration Month Codes
Strike Price Codes
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Types of options
Real option (real option) is a choice that an investor has when investing in the real economy (i.e. in the production of goods or services, rather than in financial contracts). This option may be something as simple as the opportunity to expand production, or to change production inputs. Real options are an increasingly influential tool in corporate finance. They are typically difficult or impossible to trade, and lack the liquidity of exchange-traded options.
Traded options (also called "Exchange-Traded Options" or "Listed Options") are Exchange traded derivatives, as the name implies. As for other classes of exchange traded derivatives, they have: standardized contracts; quick systematic pricing; and are settled through a clearing house (ensuring fulfillment.) These include
Vanilla options are 'simple', well understood, and traded options; Exotic options are more complex, or less easily understood. Asian options, lookback options, barrier options are considered to be exotic, especially if the underlying instrument is more complex than simple equity or debt.
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Valuation
The premium for an option contract is ultimately determined by supply and demand, but is influenced by five principal factors:
The price of the security,
The cumulative cost required to hold a position in the security (including interest + dividends),
The estimate of the future volatility of the security's price. This is perhaps the least-known input into any pricing model for options, therefore traders often look to the marketplace to see what the implied volatility of an option is -- meaning that given the price of an option and all the other inputs except volatility you can solve for that value.
Pricing models include the binomial options model for American options and the Black-Scholes model for European options. Even though there are pricing models, the value of an option is a personal decision, requiring multiple trade offs and depending on the investment objective. See the Excel model * for the metrics of a call option.
Because options are derivatives, they can be combined with different combinations of
the underlying security, and
futures contracts on that security
to create a risk neutral portfolio. In a liquid market, arbitrageurs ensure that the values of all these assets are 'self-leveling', i.e. they incorporate the same assumptions of risk/reward. In theory traders could buy cheap options and sell expensive options (relative to their theoretical prices), in quantities such that the overall delta is zero, and expect to make a profit. Nevertheless, implementing this in practice may be difficult because of "stale" stock prices, large bid/ask spreads, market closures and other symptoms of stock market illiquidity. If stock market prices do not follow a random walk (due, for example, to insider trading) this delta neutral strategy or other model-based strategies may encounter further difficulties. Even for veteran traders using very sophisticated models, option trading is not an easy game to play.
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History of valuation
Models of option pricing were very simple and incomplete until 1973 when Fischer Black and Myron Scholes published the Black-Scholes pricing model. Scholes received the 1997 Bank of Sweden Prize in Economic Sciences (Nobel Prize of Economics) for this work, along with Robert C. Merton. In a departure from tradition, Fischer Black was specifically mentioned in the award, even though he had died and was therefore not eligible.
The Black-Scholes model gives theoretical values for European put and call options on non-dividend paying stocks. The key argument is that traders could risklessly hedge a long options position with a short position in the stock and continuously adjust the hedge ratio (the delta value -- one of the option sensitivities known as "greeks") as needed. Assuming that the stock price follows a random walk, and using the methods of stochastic calculus, a price for the option can be calculated where there is no arbitrage profit. This price depends only on 5 factors: the current stock price, the exercise price, the risk-free interest rate, the time until expiration, and the volatility of the stock price. Eventually, the model was adapted to be able to price options on dividend paying stocks as well.
The availability of a good estimate of an option's theoretical price contributed to the explosion of trading in options. Other option pricing models have since been developed for other markets and situations using similar arguments, assumptions, and tools, including the Black model for options on futures, Monte Carlo methods, Path Integrals, and Binomial options models.
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Risks
As with investing in any security, trading options entails risks to both the seller and the buyer. These risks are different from those associated with trading the underlier and, depending on which strategies are used, can be significantly larger in magnitude.
The primary risk to an option seller is that an 'in-the-money' option will be exercised, in which case the seller is obliged to either sell (for a call) or buy (for a put) the underlying security at the option's strike price. His downside risk is limited to the strike price of the contract for puts (again, minus the premium received), but is unlimited for calls.
The primary risk to an option buyer is that the option will expire 'out-of-the-money', meaning he receives nothing in exchange for the premium paid. This can be considered a 100% loss of an investment.
In general, option trading is relatively more complicated than trading the underlying security and there may be other potential risks to consider.
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Trading
The most common way to trade stock options is trading standardized options contracts that are listed by various futures and options exchanges -- there are currently six exchanges in the United States that list standardized options contracts based on underlying stocks -- The Philadelphia Stock Exchange (PHLX), American Stock Exchange (AMEX) and NYSE Arca in New York City, and the Chicago Board Options Exchange (CBOE) which are all open-outcry marketplaces, and the International Securities Exchange (ISE) and Boston Options Exchange (BOX) are electronic marketplaces. However, even for the non-electronic exchanges, competition and the introduction of automated execution (AutoEx) has led, by late 2006, to hybridization where all but the largest trades are executed electronically. In Europe the main exchanges where stock options are traded are Euronext.liffe and Eurex.
There are also over-the-counter options contracts that are traded not on exchanges, but between two independent parties. At least one of those parties is usually a large financial institution with a balance sheet big enough to underwrite such a contract.
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Option uses
One can combine options and other derivatives in a process known as financial engineering to control the risk in a given transaction. By using options, one party transfers (buys or sells) risk to or from another. When using options for insurance, the option holder reduces the risk he bears by paying the option seller a premium to assume it.
Because one can use options to assume risk, one can purchase options to create leverage. The payoff to purchasing an option can be much greater than by purchasing the underlying instrument directly. For example buying an at-the-money call option for 2 monetary units per share for a total of 200 units on a security priced at 20 units, will lead to a 100% return on premium if the option is exercised when the underlying security's price has risen by 2 units, whereas buying the security directly for 20 units per share, would have led to a 10% return. The greater leverage comes at the cost of greater risk of losing 100% of the option premium if the underlying security does not rise in price.
Other instruments to manage risk or to assume it include:
Employee stock options are also widely used as a compensation vehicle for employees and, in particular, senior executives of publicly traded corporations. However, employee stock options use is being curbed thanks in part to a decision by the Financial Accounting Standards Board (FASB) requiring that stock option grants are recorded on the income statement as an expense. Previously, options granted with fair market value exercise prices were not considered to have a cost to the company. This was a significant factor in their ascendancy as a compensation tool.
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The basic trades or traded stock options
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These trades are described from the point of view of a speculator. If they are combined with other positions, they can also be used in hedging.
Long Call
A trader who believes that a stock's price will increase may buy the right to purchase the stock (a call option) rather than just buy the stock. He would have no obligation to buy the stock, only the right to do so until the expiry date. If the stock price increases over the exercise price by more than the premium paid, he will profit. If the stock price decreases, he will let the call contract expire worthless, and only lose the amount of the premium. A trader might buy the option instead of shares, because for the same amount of money, he can obtain a larger number of options than shares. If the stock rises, he will thus realize a larger gain than if he had purchased shares.
Short Call (Naked short call)
A trader who believes that a stock's price will decrease can short sell the stock or instead sell a call. Both tactics are generally considered inappropriate for small investors. The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's option. If the stock price decreases, the short call position will make a profit in the amount of the premium. If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money. Unless a trader already owns the shares which he may be required to provide, the potential loss is unlimited. However, such a trader who sells a call option for those shares he already owns has sold a covered call.
Long Put
A trader who believes that a stock's price will decrease can buy the right to sell the stock at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until the expiry date. If the stock price decreases below the exercise price by more than the premium paid, he will profit. If the stock price increases, he will just let the put contract expire worthless.
Short Put (Naked put)
A trader who believes that a stock's price will increase can sell the right to sell the stock at a fixed price. The trader now has the obligation to purchase the stock at a fixed price. The trader has sold insurance to the buyer of the put requiring the trader to insure the stockholder below the fixed price. This trade is generally considered inappropriate for a small investor. If the stock price increases, the short put position will make a profit in the amount of the premium. If the stock price decreases below the exercise price by more than the premium, the short position will lose money.
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Introduction to option strategies
Combining any of the four basic kinds of option trades (possibly with different exercise prices) and the two basic kinds of stock trades (long and short) allows a variety of options strategies. Simple strategies usually combine only a few trades, while more complicated strategies can combine several.
Covered call — Long the stock, short a call. This has essentially the same payoff as a short put.
Straddle — Long a call and long a put with the same exercise prices (a long straddle), or short a call and short a put with the same exercise prices (a short straddle).
Strangle — Long a call and long a put with different exercise prices (a long strangle), or short a call and short a put with different exercise prices (a short strangle).
Bull spread — Long a call with a low exercise price and short a call with a higher exercise price, or long a put with a low exercise price and short a put with a higher exercise price.
Bear spread — Short a call with a low exercise price and long a call with a higher exercise price, or short a put with a low exercise price and long a put with a higher exercise price.
Butterfly — Butterflies require trading options with 3 different exercise prices. Assume exercise prices X1 < X2 < X3 and that (X1 + X3) /2 = X2
Long butterfly — long 1 call with exercise price X1, short 2 calls with exercise price X2, and long 1 call with exercise price X3. Alternatively, long 1 put with exercise price X1, short 2 puts with exercise price X2, and long 1 put with exercise price X3.
Short butterfly — short 1 call with exercise price X1, long 2 calls with exercise price X2, and short 1 call with exercise price X3. Alternatively, short 1 put with exercise price X1, long 2 puts with exercise price X2, and short 1 put with exercise price X3.
Box spreads — Any combination of options that has a constant payoff at expiration. For example combining a long butterfly made with calls, with a short butterfly made with puts will have a constant payoff of zero, and in equilibrium will cost zero. In practice any profit from these spreads will be eaten up by commissions (hence the name "alligator spreads").
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Historical uses of options
Contracts similar to options are believed to have been used since ancient times. In the real estate market, call options have long been used to assemble large parcels of land from separate owners, e.g. a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the right — but not the obligation — to dramatize a specific book or script.
Lines of credit give the potential borrower the right — but not the obligation — to borrow within a specified time period.
Many choices, or embedded options, have traditionally been included in bond contracts. For example many bonds are convertible into common stock at the buyer's option, or may be called (bought back) at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the loan early.
Privileges were options sold over the counter in nineteenth century America, with both puts and calls on shares offered by specialized dealers. Their exercise price was fixed at a rounded-off market price on the day or week that the option was bought, and the expiry date was generally three months after purchase. They were not traded in secondary markets.
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Related
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See also
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Options
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Literature
Kleinert, Hagen, Path Integrals in Quantum Mechanics, Statistics, Polymer Physics, and Financial Markets, 4th edition, World Scientific (Singapore, 2004); Paperback ISBN 981-238-107-4 (also available online: PDF-files)
Investigation of Companies for Manipulating Stock Option Grants - http://www.chimicles.com/backdated/Chimicles+Tikellis%20BackDatedStockOptions%20PressRelease2.pdf
Are CEOs Paid for Luck, Marianne Bertrand and Sendhil Mullainathan, Quarterly journal of Economics, 2001.
Are CEOs paid like Bureaucrats?, Brian Hall & Jeffrey Liebman, Quarterly journal of Economics, 1998.
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