This writeup is on options in finance. In a nutshell, an
option is the right to buy or sell an asset, often shares.
This can be found with a quick Internet search; However, a lot more can be
said about options. I'll warn right away that this is in no way an
exhaustive description of options; rather, I'll try to give an overview
about what currently the most important things about options are from the
point of view of an interested layperson. Even though I can't be
exhaustive, I do want to be a bit thorough, so I'll give a rather precise
explanation of what an option is first.
An option is a contract. This can be a direct contract between two
parties; this is called an Over the counter option, and exposes you to the
risk that your counterparty can't make his obligations.
It can also be settled using the exchange; in this case, the counterparty
doesn't matter that much, and the option can be traded. This is a pretty
important one: an option is not an asset in the same way a share is or a
barrel of crude oil is. It's a contract. It doesn't give you voting rights or dividend or whatever. Normally, options you buy
or sell are transferred via the exchange.
Historically, an option is either the right, but not the obligation,
to buy or the right to sell (one option typically isn't the right to
either sell or buy!) an underlying asset at a fixed price, called the
strike, within a certain timeframe or at a certain time. This is
the classic definition of an option, and nowadays a bit inadequate. We can
make a few remarks about this:
- This buying and selling doesn't necessarily happen. Many options are
settled in cash, i.e. the profit you would have made if you would have
bought the asset at the strike and sold it at the price at the time the
option is exercised (the settlement price, provided this amount is
positive. If it is not positive, the payout is 0-never lower! If the buying
or selling does happen, it is called physical delivery. Said delivery
might be several tonnes of pork bellies, so it's worthwhile to check the
contract for this. Speaking about contract: one contract is an option on a
certain amount of assets. For shares, this amount is usually more
than one share; 100 is typical. Of course, you can buy more options to get
more assets, but never less than this contract size.
- The underlying isn't necessarily an asset. It might be a future ON
the asset, an index, or even an option! This asset is usually rather
specific. As an example, some companies list two types of shares.
You can't deliver one share if the option calls for the other. This may
seem like a no-brainer, but in practice, people might hedge the options
with a very similar but different asset, leading to basis risk.
- A buying right is called a call. A selling right is called a put.
- In some cases, the strike isn't fixed.
- One big difference between options is the exercise style. The main
types for investors are European style, which means that the option only can
be exercised at the last day the contract lasts (the expiry), and the
American style meaning the options can be exercised daily until expiry.
Slightly less common are Asian options, which are not settled on the price
at expiry, but rather at the average price between a certain time and
expiry, and the Bermudan option, which can be exercised at certain dates
until expiry. It is worth noting that many European options have a so-called
Asian tail: this means the option isn't settled at one price, but rather
at an average over a short time before expiry - half an hour is typical.
This doesn't significantly impact pricing, but makes market manipulation
more difficult. For a real Asian option, this averaging is over a much
longer period. It's also important to note that these name have nothing to
do with location, Asian, European and American options are all traded
everywhere. As a rule of thumb, options that are settled physically are
American, and cash-settled options are European, but there are many
exceptions.
Options are also valuable. You have the right, but not the obligation,
so if exercise would cost money, you simply don't do it. Pricing options
is a very interesting field that is part art, part science and part
goat entrails. For European options, a "solution" called the
Black-Scholes equation exists, but that uses assumptions that are wrong
and inputs that are unknown. It's used in option pricing, but with a lot
of quasi-mathematical modeling and gut feeling attached to it. In
general, an option is worth what the market is willing to pay for it.
Arbitraging options is a rather complex specialty of a few
hedge funds and market makers.
An option contract has two sides: buying and selling. If you buy the
option, you pay money and get the right, but not the obligation. If
you sell the option, you receive the money and you have no right, but
you do have the obligation. Hence, options are a zero-sum game. Anything
the buyer makes, the seller loses, and vice-versa.
So, now we have, at least in theory, a fairly complete picture of what
options can do. Let's look at some examples to clarify matters a bit more
Imagine we think that Exxon (XOM) will go up. It is currently trading
73.68, but we think it will go up- in fact, we think it will go up quite a
bit. Hence, we buy the Jan 09 80 Call (this is the proper slang - casually
mention it to your broker and sound like a pro). Jan 09 means that the
option will expire in January 2009, and normally on the third Friday, at the
close, which is at 16.00. Our call gives us the right to buy 100
shares of Exxon for $80 at, or before, January 16, 2008. I pay $4.35 * 100
for this right. Hence, we will make a profit if Exxon is above $84.35 - the
strike of $80 plus the $ 4.35 paid for the call. This profit is
multiplied by 100, because one option contract is for 100 shares. Note
that option prices are always quoted per share, not per contract! If Exxon
is above $80, but below $ 4.35, we do make a bit of profit, as we can buy
the shares for $80 and sell them for more, but this is not enough to
recoup the price of the option, so we make a net loss.
Now, imagine, Exxon doesn't go up, but it goes down, quite a bit, to
55. If I would have bought shares, I would have lost nearly $20, but with
my option, my loss is capped at $4.35. In this sense, options can be safer
than shares, provided they are used responsibly.
Speculating on a move up or down is something we could have done
anyway. by buying shares. However, with options, we can also
speculate on movement. We can do this by buying a straddle. This is a
combination of a call and a put with the same strike. In this case, I
can buy the Jan 09 75 call for $ 6.60 and the Jan 09 75 put for $ 7.90. This
will set us back $14.50 - times 100 because the contract size is 100. If
Exxon closes above $75, we can exercise the call and pocket the
difference. If Exxon closes below $75, we can exercise the put and pocket
the difference. Hence, we make a net profit if Exxon closes below $ 60.50
or above $89.50.
Options are hence quite a bit more versatile and powerful than
stocks. An apt metaphor might be the difference between an old,
dull knife and a very sharp knife. If you know what you are doing,
working with sharp knives is actually safer, as you are a lot less likely to
cut yourself. However, a total klutz will cut himself anyway, and in that
case, a sharp knife can cause a lot more damage. Hence, be careful with
options, and don't take this as investment advice.
In this writeup, we have merely scratched the surface of what
options are and how we can use them for trading. Many good books
have been written on this subject; I personally prefer John Hull's
Options, Futures, and Other Derivatives, which is a bit mathy but
quite thorough. I've also heard good things about Sheldon Natenberg's
Option Volatility & Pricing: Advanced Trading Strategies and
Techniques.
Sources:
- I got the option prices from Yahoo Finance,
http://finance.yahoo.com/q/op?s=XOM, at November 16 2008