What are Options?
As promised in my previous blog I am posting some option basics in this post.
Options are derivatives (refer to previous blog for derivative basics). Options derive their value form the underlying value of the stock or index they follow. Let just stick to the options for the stocks for ease of understanding.
An option is a contract which is a right to buy (called call option) or right to sell (called put option) a predetermined number of shares of a certain company at a pre-determined price on or before the specified expiry date. The owner of call or put option has the right (but not an obligation) to buy or sell that quantity of shares at the pre-determined strike price no matter what the market price of that stock is. The buyer does pay a certain price per share to have this option of buying/ selling the stock at that strike price.
Writing an Option
Investor writes an option when they sell or give someone the right to buy or sell (you sell a call or put) and while they take up the obligation. So the buyer of an option who buys this right (option) from you pays you in exchange for that right. This price depends on the then current market value.
American Options
In American exchanges, options are generally contracts representing 100 shares. So 5 option contracts will include 500 shares. There may be options for odd number of shares and an investor has to be vigilant about that. Also the options in American exchanges expire on the Saturday following the third Friday. So they must be traded/ exercised by that Friday.
Types of Options
Call Options
Call Option is the right but not an obligation to buy the predetermined number of shares of a certain company at a pre-determined strike price on or before the specified expiry date. So to buy an option which is traded in the market you have to pay the current trading price for that option.
Example:
The Call Option buyer paid $1.5/ share (i.e. 150 for a lot of 100 shares) for the right to buy 100 shares of XYZ company at a strike price of $10 with expiry of July 2009 (17 JUL 2009). So the buyer has spent $ 150 already for such a right. If the market price of a share of XYZ company is less $ 10 then it doesn’t make sense for option owner to exercise the option and buy shares at strike price of $10. But say that the current share price is $20 then it makes sense for the call option owner to buy the shares at a strike price of $10. To have such a right the option buyer has paid $1.50 per share which is called premium. Looking at the math behind the deal. So the intrinsic value of this call option will be current price ($20)- strike price($10) i.e. $10/ share. But the call buyer has already paid $1.50/ share so the call option buyer will net $8.50 using this trade.
We know that the option described above should trade at atleast $10/ share (intrinsic value). Now considering today’s date of 1st June 2009, this option has 47 days to expire and the current share price is already above the strike price. Investors trading these call options will look for a premium which is more than the intrinsic value and is based on the price speculation based on time to expire of this option is called time value. So if this option trades at $10.5 per share then $ 10 is the intrinsic value (current share price-strike price) and $0.5 per share is the time value.
Put Option
Put Option is the right but no obligation to sell the predetermined number of shares of a certain company at a pre-determined strike price on or before the specified expiry date.
Example
The Put option buyer paid $1.5 per share (i.e. 150 for a lot of 100 shares) for the right ot sell 100 shares of XYZ company at a strike price of $10 with expiry of July 2009. So the buyer of this put option paid $1.50 for such a right. If the market price of one share of XYZ company is more than $10 the it doesn’t make sense for the option owner to exercise the option and sell the shares at the strike price of $10. But say that the current share price for this company is $ 5 the it makes sense for the put option owner to sell the shares at the strike price of $10. To have such a right the option seller has paid $1.50 per share which is called premium.
We know that the option described above should trade at atleast $5/ share (intrinsic value). Now considering today’s date of 1st June 2009, this option has 47 days to expire and the current share price is already above the strike price. Investors trading these call options will look for a premium which is different than the intrinsic value and is based on the price speculation based on time to expire of this option is called time value. So if this option trades at $5.5 per share then $ 5 is the intrinsic value (strike price-current stock price) and $0.5 per share is the time value.
In/ Out of the Money
An option is “In the Money” when the trading price of the underlying stock crosses the strike price in a favorable direction (stock trading above the strike price for call options and stock trading below the strike price for put options). So the call in the above example will be in the money when the share price is above $10 (strike price) and put will be in the money when the share price is below $5 (strike price)
An option is “Out of the Money” when the trading price of the underlying stock has not crossed the strike price in a favorable direction (stock trading below the strike price for call options and stock trading above the strike price for put options). So the call in the above example will be out of the money when the share price is below $10 (strike price) and Put will be out of the money when the share price is above 5 (strike price)
Warning
Before trading options an investor has to realize that options are far more volatile than the underlying stock. So an investor should not expect option’s trading price to fluctuate proportional to its underlying stock. Also extreme caution is advised during writing an option as the option writer has to oblige when the investor buying that option decides to exercise the option. More on option strategies later!
As promised in my previous blog I am posting some option basics in this post.
Options are derivatives (refer to previous blog for derivative basics). Options derive their value form the underlying value of the stock or index they follow. Let just stick to the options for the stocks for ease of understanding.
An option is a contract which is a right to buy (called call option) or right to sell (called put option) a predetermined number of shares of a certain company at a pre-determined price on or before the specified expiry date. The owner of call or put option has the right (but not an obligation) to buy or sell that quantity of shares at the pre-determined strike price no matter what the market price of that stock is. The buyer does pay a certain price per share to have this option of buying/ selling the stock at that strike price.
Writing an Option
Investor writes an option when they sell or give someone the right to buy or sell (you sell a call or put) and while they take up the obligation. So the buyer of an option who buys this right (option) from you pays you in exchange for that right. This price depends on the then current market value.
American Options
In American exchanges, options are generally contracts representing 100 shares. So 5 option contracts will include 500 shares. There may be options for odd number of shares and an investor has to be vigilant about that. Also the options in American exchanges expire on the Saturday following the third Friday. So they must be traded/ exercised by that Friday.
Types of Options
Call Options
Call Option is the right but not an obligation to buy the predetermined number of shares of a certain company at a pre-determined strike price on or before the specified expiry date. So to buy an option which is traded in the market you have to pay the current trading price for that option.
Example:
The Call Option buyer paid $1.5/ share (i.e. 150 for a lot of 100 shares) for the right to buy 100 shares of XYZ company at a strike price of $10 with expiry of July 2009 (17 JUL 2009). So the buyer has spent $ 150 already for such a right. If the market price of a share of XYZ company is less $ 10 then it doesn’t make sense for option owner to exercise the option and buy shares at strike price of $10. But say that the current share price is $20 then it makes sense for the call option owner to buy the shares at a strike price of $10. To have such a right the option buyer has paid $1.50 per share which is called premium. Looking at the math behind the deal. So the intrinsic value of this call option will be current price ($20)- strike price($10) i.e. $10/ share. But the call buyer has already paid $1.50/ share so the call option buyer will net $8.50 using this trade.
We know that the option described above should trade at atleast $10/ share (intrinsic value). Now considering today’s date of 1st June 2009, this option has 47 days to expire and the current share price is already above the strike price. Investors trading these call options will look for a premium which is more than the intrinsic value and is based on the price speculation based on time to expire of this option is called time value. So if this option trades at $10.5 per share then $ 10 is the intrinsic value (current share price-strike price) and $0.5 per share is the time value.
Put Option
Put Option is the right but no obligation to sell the predetermined number of shares of a certain company at a pre-determined strike price on or before the specified expiry date.
Example
The Put option buyer paid $1.5 per share (i.e. 150 for a lot of 100 shares) for the right ot sell 100 shares of XYZ company at a strike price of $10 with expiry of July 2009. So the buyer of this put option paid $1.50 for such a right. If the market price of one share of XYZ company is more than $10 the it doesn’t make sense for the option owner to exercise the option and sell the shares at the strike price of $10. But say that the current share price for this company is $ 5 the it makes sense for the put option owner to sell the shares at the strike price of $10. To have such a right the option seller has paid $1.50 per share which is called premium.
We know that the option described above should trade at atleast $5/ share (intrinsic value). Now considering today’s date of 1st June 2009, this option has 47 days to expire and the current share price is already above the strike price. Investors trading these call options will look for a premium which is different than the intrinsic value and is based on the price speculation based on time to expire of this option is called time value. So if this option trades at $5.5 per share then $ 5 is the intrinsic value (strike price-current stock price) and $0.5 per share is the time value.
In/ Out of the Money
An option is “In the Money” when the trading price of the underlying stock crosses the strike price in a favorable direction (stock trading above the strike price for call options and stock trading below the strike price for put options). So the call in the above example will be in the money when the share price is above $10 (strike price) and put will be in the money when the share price is below $5 (strike price)
An option is “Out of the Money” when the trading price of the underlying stock has not crossed the strike price in a favorable direction (stock trading below the strike price for call options and stock trading above the strike price for put options). So the call in the above example will be out of the money when the share price is below $10 (strike price) and Put will be out of the money when the share price is above 5 (strike price)
Warning
Before trading options an investor has to realize that options are far more volatile than the underlying stock. So an investor should not expect option’s trading price to fluctuate proportional to its underlying stock. Also extreme caution is advised during writing an option as the option writer has to oblige when the investor buying that option decides to exercise the option. More on option strategies later!
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