Understanding options in a quick and easy way
An option is financial derivative.
The word “financial” means that options are used at the financial markets, be it the stock market or the futures exchange. The word “derivative” means that an option and its price is dependent on the underlying asset (stock, future…).
Example: There can be a call option on the shares of Amazon. The price of this call option is dependant from the development of the Amazon stock. Without the Amazon stock, the option would lose its meaning.
An option is the right for the option holder to enter into a transaction (buy or sell) at a pre-agreed price, quantity, time and terms. For every option, there are both an option holder and an option writer.
- The holder of an option (the one who bought the option) has the right to buy or sell the underlying asset.
- The writer of an option (the one who sold the option) has the obligation to sell or buy the underlying asset.
Example: John bought from Brandon a call option on Amazon shares which gives John the right to buy the shares…
Every option has a price which is called “premium”.
- The option writer sells options and collects premiums;
- The option holder buys a right which he can use in the future.
Example: John, as the option holder, paid for the call option a premium to Brandon, who is the option writer. John has now the choice, whether he will make use of the right to buy Amazon shares or not.
There are two types of options:
- Call option – giving the option holder the right to buy the underlying asset at a fixed price.
- Put option – giving the option holder the right to sell the underlying asset at a fixed price.
Example: John wants to have the chance to buy the shares of Amazon in the future at a fixed price. Maybe, he expects that the price will increase, but at the moment, he does not want to buy the Amazon shares directly. That is why he bought the call option on Amazon. (Note: John as the option holder can also buy a put option to have the right to sell Amazon shares at a fixed price.)
Besides price, an option has expiration date, strike price and multiplier.
There are different characteristics of an option. These determine for example how long an option is valid, what the price is for which the option holder can buy or sell the underlying asset and how many underlying assets the option holder can buy thanks to the option.
Example: A call option on Amazon can be described as follows: AMZN Sept15’17 1020 CALL @8
AMZN: Symbol of Amazon shares;
Sept15’17: Expiration date of this option, meaning that the option is valid only until 15 September 2017. After this date, the right of the option holder expires;
1020: Strike price of the option. In this example, John has the right to buy the shares of Amazon for the price $1020 each. John will use this right only, if he can have some profit from his right.
CALL: Call option
@8: Option premium, the holder (John) paid to the option writer (Brandon). This value is multiplied by 100, as one option relates to 100 shares. In this case, the price of the option was $800.
The multiplier in stock options is, as a rule, 100 shares. This means that John can buy, thanks to his 1 call option, 100 shares of Amazon for the fixed price.
Depending whether the strike price of an option is above or below the current price of the underlying asset (Amazon shares), an option can be:
- Out-of-the-money (OTM) when the strike price of a call option is above the current price of the stock;
- At-the-money (ATM) when the strike price of a call option is the current price of the stock;
- In-the-money (ITM) when the strike price of a call option is below the current price of the stock.
Example: Brandon as the option writer sold to John an AMZN Sept15’17 1020 CALL @8 option which is out-of-the-money. This is because the strike price of the option (1020) is above the current price of Amazon (979). If the price of Amazon stock does not exceed 1020, John will not decide to use his right (as he could buy the stock cheaper directly for the market price) and the option will expire worthless. As a result, this is good for Brandon who earned the option premium.
These are the very basics as the first introduction to the “OPTIONLAND”. It is just a tiny drop in the ocean. Therefore, for more information about options, check the “LEVEL UP” section on this website.