An option is a contract between two parties for future transaction on an asset at a predetermined Strike price. The buyer of the option has right but is not obliged to engage in this transaction. The seller of the option on the other hand has the obligation to fulfill the transaction. The buyer of options also pays a fee for this right which is called a premium. In options transactions there must always be a buyer and a seller.
There are many different types of options for different assets. For the purpose of simplicity this introduction will be solely focused on stock options. In general, there are two different kinds of options call options and put options
When purchasing a call option, the buyer has the right but not obligation to buy agreed lots of 100 shares of the stock before the expiration date for a certain price. While the seller has the obligation to sell the stock should the buyer exercise his option.
When purchasing a put option, the buyer has the right but not obligation to sell agreed lots of 100 shares of the stock before the expiration date for a certain price. While the seller has the obligation to buy the stock at the strike price should the buyer exercise his option.
The table below shows which options you would buy or sell depending on where you believe the stock will move.
|Call Option||Put Option|
The payoffs for each of these scenarios is shown below.
Each Stock Option Contract Contains:
- Whether holder has right to buy or sell
- Strike price, the price where the transaction will occur upon exercise
- Expiration date
- Whether writer delivers assets or cash on exercise
The strike price on options contracts is the price at which an option may be exercised. These prices are fixed into the options contract. For call options it is the price at which the security may be bought up to the expiration date while for puts it is the price the security may be sold at.
Intrinsic and Time Value:
The intrinsic value of an option is its value if it were to be exercised immediately. The calculation is just the difference in stock price versus the price of the option. This means if the underlying securities current price is greater than the options strike price a call has positive intrinsic value while a put has zero value.
Time value refers to the premium that an investor would pay in excess of the current intrinsic value for the right to buy or sell at a future date. This is based on the options potential of increasing in value and arises from the uncertainty of future prices.
In the Money:
Options are considered in the money if the time value and intrinsic value are both positive values. For a call option this occurs when the strike price is below the spot price. For a put option this occurs when spot price is above the strike price.
At the Money:
Options are considered at the money if the time value is positive and the intrinsic value is zero.
Out of the Money:
Options are considered out of the money if they have no intrinsic value. For a call option this occurs when the strike price is above the spot price. For a put option this occurs when the spot price is below the strike price.
American Vs. European Options:
This has nothing to do with the geographical location of where the options are being bought or sold. An American option may be exercised at any time up until and including the options expiration date. European options on the other hand can only be exercised on the contract’s expiration date.
Collateral that the holder of a financial instrument needs to put up in order to write the option. This cost can be put up as cash or securities and is deposited in a margin account. decided based on SPAN (Standard portfolio analysis of risk) this set of algorithms was created by the Chicago Mercantile Exchange. The link below details how it is applied.
SPAN link: https://www.cmegroup.com/clearing/risk-management/span-overview.html
Factors Impacting Stock Option Value:
Current value of underlying asset – Options premiums are determined by the underlying value of the asset. As the value of the underlying stock changes so will the premium associated with that option.
Variance of value in the underlying asset – This refers to the volatility in the stock price. The higher the volatility the more likely the asset will move up and down a lot. This means that there is higher likelihood of your option being in the money at some point before its expiration date. This causes an option to be worth more.
Dividends paid on the underlying asset – Since dividends are only paid out to shareholders options holders do not get to partake. So, dividends paid during the life of the option can reduce the value.
Strike price agreed upon – Strike prices help determine the premium on the price of an option.
Time to maturity/expiration – The longer an option is held the higher the uncertainty of the outcome. So, over a longer time there is a higher possibility of an option being in the money causing the option to be more valuable. The closer the option is to the expiration date the less valuable it becomes.
Risk free interest rates – An increase in Interest rates cause call options to increase in value and puts to decline. A decrease causes calls to decrease in value and puts to increase.
Options Pricing models:
The models used to price and trade options will be covered in the next post along with a case study that applies one of the models to a current option contract.