A type of derivative instrument, an option is contract that gives the holder (the buyer), the right but not the obligation to buy or sell an underlying asset at a predetermined price (known as the strike price) on or before a predetermined date from the writer (the seller). Deriving their value from the price of an underlying financial asset, more than 17-million standardised option contracts are traded daily across more than 3,000 securities, on more than fifty global exchanges.show more
An options contract has two active participants: an options holder and an options writer. The writer (or grantor) is the seller of the option contract while the buyer is known as the holder (or buyer-taker). Used to speculate or hedge against risk, the option holder predicts significant movements in the underlying asset price while the option writer – who receives income in the form of a premium for selling the contract – anticipates stable asset prices.
Every option contract has a unique ticker symbol. Made up of 21 characters (letters and numbers), the option ticker symbol lists: the underlying stock, expiration date (year, month, day), option type (call or put) and strike price (in dollars to three decimal places).
EXAMPLE: The option symbol AAPL170721C00600000 represents: APPL (Root Symbol) 17 (Year) 07 (Month) 21 (Expiration Day), C (Type of Option) and 00600000 ($600.00 Strike Price).
Options contracts are classed as either call or put options, allowing a trader the opportunity to profit from both a rising and falling market.
A contract between two parties, a call option (referred to as a ‘call’), gives the holder the right (but not the obligation) to buy a quantity of an underlying asset from the writer at the strike price on or before a predetermined date.
Used to profit from a rising market, when the holder buys a call option, it gives them the right to buy the asset at the strike price, regardless of the future stock price before the expiration date. If the call option is exercised, the option holder must purchase the underlying asset from the option writer at the strike price (plus the premium). If the option expiration date passes without the option being exercised, then the option expires worthless and the holder forfeits the premium amount to the writer.
A call option would normally be exercised only when the strike price is below the market value of the underlying asset.
Conversely, a put option (also known as a ‘put’), gives the holder the right (but not the obligation) to sell a quantity of an underlying asset to the writer at a specific price on or before a predetermined date.
Used to profit from a falling market, when the holder buys a put option, it gives them the right to sell the asset at the strike price, regardless of the future stock price before the expiration date. If the put option is exercised, the option writer must purchase the underlying asset from the option holder at the strike price. If the option expiration date passes without the option being exercised, then the option expires worthless and the holder forfeits the premium amount to the writer.
A put option would normally be exercised only when the strike price is above the market value.
An options contract is an agreement between a holder and a writer facilitating a possible transaction of an underlying asset at a strike price on (or before) expiration.
Exchanged-traded contracts are standardised – that is, the underlying asset, quantity, expiration date, exercise style and strike price are confirmed in advance. Traded on a regulated exchange and settled through a clearing house, a standardized option is known as a ‘vanilla option’.
An ‘exotic option’ is a non-standardised options contract. Traded in the over-the-counter market, exotic options are customised contracts, traded directly between counterparties.
Options are derivative financial instruments. That is, their prices are intrinsically linked to the price of an underlying asset such as a stock, a bond, futures, an index, a commodity, interest rate or a currency. In a standardised option contract, the contract will list the underlying asset as well as the contract size (the deliverable quantity of the underlying asset in the event of options contract being exercised).
Option contracts have an expiration date. The expiry date is the last day on which the holder of the option may exercise it according to the contract terms – after which date the holder no longer has any right to the underlying asset.
If at expiry the option is ‘in-the-money’ – that is, a call option’s strike price is below the market price of the underlying asset or that the strike price of a put option is above the market price of the underlying asset – the holder will exercise the option and realise a profit.
If at expiry the option is ‘out-of-the-money’ – that is, a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset – the option will expire worthless and the premium paid by the holder is lost to the writer.
Exchange-traded option contracts expire according to a pre-determined calendar – typically weekly, monthly or quarterly.
An options contract specifies when that option can be exercised and is classified as either ‘American’ or ‘European’ style.
The most popular exercise style, an option that can be exercised at the strike price on any trading day on or before expiration is referred to as an American-style option. An option which can only be exercised at the strike price on expiry is referred to as a European-style option.
An American-style option is typically more expensive (higher risk premium) than the European-style primarily due the increased risk associated assumed by the writer (or seller).
The strike price, also known as the exercise price, is the fixed price at which a call or put option can be exercised. set Determined by reference to the spot price (current market price) and fixed for the term of the option contract, the strike price is defined for every option.
Strike Price Interval
The strike price interval is the price differential between option strike prices listed by the exchange. Identified as the gap between two strike prices and available in several strike prices above and below the current price of the underlying asset, option traders must choose only between available strike prices offered to the market.
Settlement is the process whereby the terms of an options contract are executed either by voluntary exercise (by the holder) or automatic exercise upon expiration. Determined by the contract specifications between the option’s holder and writer, contracts are either cash settled or physically delivered.
Physical settlement refers to the process whereby the actual underlying asset covered by the terms of the option is delivered to its holder when the option is exercised. A Cash Settled option implies only the profit in cash is delivered to the holder instead of the underlying asset itself. The cash amount settled is the difference between the strike price and the current value of the underlying asset at expiry (or exercise).
The price of an option is known as the premium. It is the price (or amount) the option holder pays to be granted specified rights for the period under the option and is classified as income that the seller receives in exchange for writing the option.
Typically calculated using the Black-Scholes options or the the binomial pricing model, an option’s premium is not a fixed amount – rather calculated accounting for parameters including time remaining until the expiration date, price of the underlying asset, risk-free interest rates, the asset’s volatility, strike price and expected dividends. For stock options, the premium is quoted as a dollar amount per share, and most contracts represent the commitment of 100 shares while for currency options, premiums are quoted either in percentage or in pips.
Calculated as the difference between the underlying asset’s current market price and the strike price, intrinsic value is the options value if it was exercised immediately at its current market value. An option is said to have intrinsic value if the option is in-the-money. When out-of-the-money, its intrinsic value is zero.
EXAMPLE: If a call options strike price is $25 and the underlying asset’s market price is at $35, then the intrinsic value of the call option is $10 ($35 – $25).
An option’s time value (also known as extrinsic value) represents the time remaining in the lifetime of the option and the estimated volatility for the underlying asset.
Calculated as the option’s premium (the cost of the option) minus its intrinsic value (the difference between the strike price and the price of the underlying), time value decreases and decays to zero at expiration (known as time decay).
Representing a premium a trader will pay above an option’s current intrinsic value based on the probability price will move further in-the-money as it moves closer to expiry – the more time that remains until expiration, the greater the time value of the option.
EXAMPLE: If a Company ABC is trading for $30 and the ABC 25 call option is trading at $12, the option has an intrinsic value of $5 ($30 – $25 = $5), and a time value of $7 ($12 – $5 = $7).