Introduction to Options

What is an Option?

 Options are not to be confused with futures, as they are two separate financial instruments.

The option seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) ‘exercises’ the option. The underlying asset/instrument could be a stock, bond, foreign currency, commodity, or any other traded instrument. Exercising means utilising the right to buy or sell the underlying security. 

Usually, an option contract should include the following specifications:

Type: whether the option holder has the right to buy (a call option) or the right to sell (a put option).

• Underlying asset and  quantity: the quantity and the underlying asset(s) (e.g.: 100 shares of Apple.Inc stock)
• Strike price: the stated price where the buyer will exercise the option
• Expiry date: the last date the option can be exercised
• Settlement terms: for instance, whether the option seller (writer) must deliver the actual asset on exercise, or whether he/she will simply tender the equivalent cash amount
• Option premium: the total amount you pay for the option.

 

Why Use Options?

There are two types of options: Call and Put. Call options allow the owner to buy a specified amount of underlying asset at a fixed price within a specific period of time while put options allow the holder to sell a specified amount of underlying asset at the strike price within a specific timeframe.

An option can also be categorised by American or European style. American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date. When you buy an option, the purchase price is called the premium. If you sell your option, the premium is the amount you receive. The premium isn’t fixed and may fluctuate based on market conditions. 

Aside from providing investors with the right to buy or sell underlying assets, there are various use cases for options¹:

Versatile securities

The advantage of options is that you are not limited to making a profit only when the market goes up. Because of the versatile nature of options, you can also make money when the market goes down or even when it moves sideways.

Speculation

If you buy an options contract, you are betting on the movement of the security. This kind of bet requires extensive knowledge of financial markets and a high risk tolerance.

Hedging

Options are used as an insurance policy to protect your stocks against a potential downturn.

Options to attract employees

Many companies use stock options as a way to attract and keep talented employees.

Different Types of Options

As mentioned before, the strike price for an option is the price at which the underlying asset is bought or sold if the option is exercised. The relationship between the strike price and the actual price of a stock determines, in the unique language of options, whether the option is in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM)².

 

In the money (ITM)

For call options, in-the-money means that strike price is below the actual stock price. 

Example: An investor purchases a call option at the $95 strike price for XYZ that is currently trading at $10. The investor’s position is in the money by $5. The call option gives the investor the right to buy the equity at $95. 

For put options, in-the-money means that strike price is above the actual stock price. 

Example: An investor purchases a put option at the $110 strike price for XYZ that is currently trading at $100. This investor position is in-the-money by $10. The put option gives the investor the right to sell the equity at $110.

At the money (ATM)

For both put and call options, the strike and the actual stock prices are the same.

Out-of-the-money (OTM) 

An out-of-the-money call option strike price is above the actual stock price. 

Example: An investor purchases an out-of-the-money call option at the strike price of $110 for XYZ that is currently trading at $100. This investor’s position is out-of-the-money by $10. An out-of-the-money put option strike price is below the actual stock price. 

Example: An investor purchases an out-of-the-money put option at the strike price of $95 for XYZ that is currently trading at $100. This investor’s position is out of the money by $5.

Payoff

You have now familiarised yourself with option basics. Now, let’s take a look at how option works and how the payoff can be derived. Payoff diagrams are charts that illustrate the profit/loss of the option as its underlying price changes, and the conditions include: long-call, short-call, long-put, and short-put.

Long-Call

Bob is bullish on Apple Inc. because he believes the new iPhone will have more functions and  will subsequently give the stock a good bump. Rather than buying shares, Bob is looking at a long position with call options, as they limit his downside while  still allowing unlimited gains if the stock price blows up. Here are some facts about his position and what the payoff will look like at various stock prices:

Given: option premium per share = $2, option strike price=$100

The breakeven point is the stock price at which an investor’s net profit will be zero:

Breakeven stock price = Strike price + premium

In this case, the breakeven price is $100 + $2 = $102. Another feature to note is that if the stock price is below the strike price, Bob will just let the options expire without using them and his losses will be limited to the premium he paid for the options. On the other hand, the profits are unlimited as the price goes higher than $102. 

Here is a formula:

Call payoff per share = MAX (stock price – strike price, 0) – premium per share

At a stock price of $98, MAX ($98 – $100, 0) – $2 = 0 – $2 = $2 per share loss

At a stock price of $105, MAX ($105 – $100, 0) – $2 = $5 – $2 = $3 profit per share

Short-Call

The writer (seller) of the call option takes a short or opposite position. His payoff graph is the opposite of the long-call we mentioned. Profits are limited to the premium he collects when the strike price exceeds the stock price and the calls are allowed to lapse. Above the strike price he faces increasing losses as the stock price increases. 

The payoff formula is:

Short call payoff per share = premium per share – MAX (0, share price – strike price)

Long-Put

In this circumstance, Bob is bearish on Apple.Inc stock as he feels that the new iPhone may be overhyped due to public anticipation. He might therefore buy a long-put option of Apple stock, through which he gains interest as long as the stock price drops below the breakeven price. His loss is also limited to the paid premium and the gain can reach a maximum when the stock price drops to 0.

Given: option premium per share = $2, option strike price=$100

Breakeven stock price = Strike price – Premium

In this case, the breakeven price is $100 – $2 = $98. If the stock price is above the strike price, Bob will just let the options expire without using them and his losses will be limited to the premium he paid for the options. On the other hand, his profits are also limited as the price can go lower than $98 and reach the maximum when the price is zero. 

Here is a formula:

Put payoff per share = MAX (strike price – stock price, 0) – premium per share

At a stock price of $103, MAX ($100 – $103, 0) – $2 = 0 – $2 = $2 per share loss

At a stock price of $95, MAX ($100 – $95, 0) – $2 = $5 – $2 = $3 profit per share

Short-Put

The writer (seller) of the put option takes a short or opposite position. His payoff graph is the opposite of the long-put position illustrated above. Profits are limited to the premium he collects when the stock price exceeds the strike price and the put options are allowed to lapse. Below the strike price he faces increasing losses as the stock price decreases. 

The payoff formula is:

Short put payoff per share = premium per share – (MAX (0, strike price-share price)