Options

An option is a contract in which the buyer has the right to buy or sell an underlying security at a specific price on or before a certain date. After this given date, the option ceases to exist. The seller of an option is obligated to sell (or buy) the shares to (or from) the buyer of the option at the specified price upon the buyer’s request. The buyer is under no obligation to sell. It is called an option because the buyer is not obliged to carry out the transaction. If, over the life of the contract, the asset value decreases, the buyer can simply elect not to exercise his/her right to buy/sell the asset.

Buyers of options are called holders while the sellers of the options are called writers. Holders are not under an obligation to buy or sell. They can exercise their right if they choose to. Writers on the other hand are under obligation to buy or sell.

Based on the rights conferred on the holders, there are two types of options: call and put. In a call option, the holder has the right to buy an underlying security at a specified price within a certain period of time whereas a put option conveys the right to sell an underlying security at a specified price within a certain period of time.

Strike price is the price at which the underlying security is brought or sold. It is the specified share price at which the shares of stock can be bought or sold by the holder, or buyer, of the option contract if he exercises his right against a writer, or seller, of the option. Strike prices are listed in increments of 21⁄2, 5, or 10 points (in the US), depending on the market price of the underlying security, and only strike prices a few levels above and below the current market price are traded. If the call option is exercised, the price of the asset must rise above the strike price to the investor to make a profit. In case of a put option, the price must fall below the strike price for the investor to make a profit. It is important that the price rise or fall must happen within a certain period of time.

Options listed on national option exchanges are called listed options and have a fixed strike price and fixed period within which they must be sold or purchased. Each listed option represents 100 shares (usually 1000 in Australia) of the company. If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the stock market. A put option having a strike price that is greater than the current market price of the underlying security is also said to be in-the-money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive selling the stock in the stock market. When the strike price is equal to the current market price of the underlying security, the option is said to be at-the-money. Intrinsic value is the amount by which the option price is higher than the strike price. The price paid by option buyers for the right to buy or sell the underlying security is called the premium and it depends on a number of factors – strike price, the specified period, etc. Premiums are quoted on a per share basis. The premium is paid to the writer, or seller, of the option. If a call option is exercised, the writer is obligated to deliver the underlying security to a call option buyer. If a put option is exercised, the writer of a put option is obligated to take delivery of the underlying security from a put option buyer. Whether or not an option is ever exercised, the writer keeps the premium.

The underlying security is the specific stock on which the option contract is based. The value of an option is derived in part from the value and characteristics of the underlying security and so they are categorized as derivative securities.

There are three styles of options. Options that give the holder the right to buy or sell at a specific price on a certain date is called European options while the ones that give the right to buy before a certain date is called US Options. It has nothing to do with geography. A Capped option gives the holder the right to exercise that option only during a specified period of time prior to its expiration, unless the option reaches the cap value prior to expiration, in which case the option is automatically exercised.

Options are extremely flexible and can be used in many combinations with other option contracts and/or financial instruments. With options investors can make profits even when the market is down. Options provide ample opportunity to use relatively moderate sums of money to leverage sizable positions for investors with a high level of risk tolerance. Option trading is very attractive for the small investor as it gives him/her the opportunity to trade a very large exposure whilst only outlaying a small amount of capital. Option contracts provide orderly, efficient and liquid markets. Generally all stock option contracts are for 100 shares of the underlying stock. Investors can buy calls giving them the right, but not the obligation, to buy shares at a specific price (strike price) for a fraction of what it would cost to buy large blocks of shares in high-flying volatile companies. Although options provide potential opportunities, options do not however pay cash dividends or convey voting rights like stocks. Options may expire worthless and an options buyer risks the entire amount paid plus any commissions paid.

Option trading provides many advantages over other investment vehicles. Leverage, limited risk, insurance, profiting in bear markets, each way betting or market going nowhere are only a few. One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless.

Another reason investors may use options is for portfolio insurance. Option contracts can give the risk averse investor a method to protect his/her downside risk in the event of a stock market crash.

Option prices are quickly and easily available at any time during trading hours. The premiums for exchange-traded options are published daily in many newspapers. The option prices are set by buyers and sellers on the exchange floor where all trading is conducted in the open, competitive manner of an auction market.

A stock option allows one to fix the price, for a specific period of time, at which one can purchase or sell 100 shares of stock for a premium which is only a percentage of what one would pay to own the stock outright. By using options one can increase the potential benefit from a stock’s price movements.

The risk for an options buyer is limited. A buyer cannot lose more than the price of the option – the premium. As the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the sale is not made by that date.

Option contracts are traded either on a public stock exchange or implicitly agreed between parties. Options traded on the stock exchange are called exchange traded options while the ones traded implicitly agreed between parties are know as OTC (Over The Counter) options.

The majority of options, however, are traded via public exchange houses. The OTC market is a complicated one, where traders from large institutions can create and trade non-standard option derivatives.

In an options market, there are four types of participants:

(i) Buyers of calls
(ii) Sellers of calls
(iii) Buyers of puts
(iv) Sellers of puts

In the U.S., options are currently traded on the following exchanges: American Stock Exchange LLC (AMEX), the Chicago Board Options Exchange, Inc. (CBOE), the International Securities Exchange (ISE), the Pacific Exchange, Inc. (PCX), and the Philadelphia Stock Exchange, Inc. (PHLX). Option trading is regulated by the Securities and Exchange Commission (SEC).

The Options Clearing Corporation (OCC) issues, guarantees and clears all option contracts traded on U.S. securities exchanges. Before the options exchanges came into existence, an option holder who wanted to exercise an option depended on the ethical and financial integrity of the writer or his brokerage firm for performance. There was no convenient means of closing out one’s position prior to the expiration of the contract. The OCC has solved these difficulties. When OCC is satisfied that there are matching orders from a buyer and a seller, it acts as the link between the parties - it becomes the buyer to the seller and the seller to the buyer. The seller can buy back the same option he has written, closing out the initial transaction and terminating his obligation to deliver the underlying stock or exercise value of the option to OCC. This will not affect the right of the original buyer to sell, hold or exercise his option. All premium and settlement payments are made to and paid by OCC.

If the holder of an option decides to exercise his right to buy in the case of a call or to sell in the case of a put, the underlying shares of stock, the holder must direct his broker to submit an exercise notice to OCC. In order to ensure that an option is exercised on a particular day, the holder must notify his broker before the broker’s cut-off time for accepting exercise instructions on that day.

Different brokers may have different cut-off times for accepting exercise instructions from clients. The cut-off times may differ for different classes of options. When the OCC receives an exercise notice, it assigns the exercise notice to one or more Clearing Members with short positions in the same series in accordance with its established procedures. The Clearing Member will then in turn, assign one or more of its customers who hold short positions in that series. The Clearing Member may choose the customer either randomly or on a first in first out basis. The assigned Clearing Member will then be obligated to sell in the case of a call or buy in the case of a put the underlying shares of stock at the specified strike price. The OCC will then arrange with a stock clearing corporation designated by the Clearing Member of the holder who exercises the option for delivery of shares of stock in the case of a call or delivery of the settlement amount in the case of a put to be made through the facilities of a correspondent clearing corporation.

A stock option usually begins trading about eight months before its expiration date. The exception is Long Term Equity Anticipation Securities (LEAPS) - options with holding times of one, two or more years. However, as a result of the sequential nature of the expiration cycles, some options have a life of only one to two months. A stock option trades on one of three expiration cycles. At any given time, an option can be bought or sold with one of four expiration dates as designated in the expiration cycle tables. The expiration date is the last day an option exists. For listed stock options, this is the Saturday following the third Friday of the expiration month. This is the deadline by which brokerage firms must submit exercise notices to the OCC; however, the exchanges and brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise.

For even more information visit: http://en.wikipedia.org/wiki/Option_%28finance%29

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