The Fundamentals of Listed Options
January 20th, 2008 by admin
What are options?
An option is a contractual agreement that gives the holder the right to buy (call option) or sell (put option) a fixed quantity of a security or commodity (for example, a commodity or commodity futures contract), at a fixed price, within a specified period of time. May either be standardized, exchange-traded, and government regulated, or over-the-counter customized and non-regulated.
An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
The Chicago Board Options Exchange (CBOE), located in Chicago, is one of the world’s largest options exchanges with an annual trade of over 450 million options contracts. It was established in 1973 when it created and listed the first exchange-listed standardized stock options.
Once the CBOE was instituted, the listed option industry began, and investors had a world of endless investment choices previously unavailable. Prior to the creation of the CBOE, investors had limited choices of where to invest their money. They could either be long or short individual stocks, or they could purchase treasury securities or other bonds.
Call Options and Put Options
Options take many forms. If you own a house or have automobile insurance, you have already dealt with the basic forms of options in your everyday life. However, in the listed options world there are only two kinds of options, Call and Put.
A call option is a financial contract between two parties, the buyer and the seller. The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity (called the underlier) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or “writer”) is obligated to sell the underlier should the buyer so decide to make the purchase. The buyer pays a fee (called a premium) for this right.
The buyer of a call option wants the price of the underlier to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price (see below for examples).
Call options are most profitable for the buyer when the underlier is moving up, making it’s price closer to the strike price. When the price of the underlier surpasses the strike price, the option is said to be “in the money”.
The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlier). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.
A put option is a financial contract between two parties, the buyer and the writer (seller). The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (underlier) to the writer (seller) of the option at a certain time for a certain price (the strike price). The writer (seller) has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option.
Note that the writer of the option is agreeing to buy the underlying asset if the buyer exercises the option. In exchange for having this option, the buyer pays the writer (seller) a fee (the premium). (Note: Although option writers are frequently referred to as sellers, because they initially sell the option that they create, thus taking a long position in the option, they are not the only sellers. An option holder can also sell his short position in the option. However, the difference between the two sellers is that the option writer takes on the legal obligation to buy the underlying asset at the strike price, whereas the option holder is merely selling his short position, and is not contractually obligated by the sold option.)
The put buyer either believes it’s likely the price of the underlier will fall by the exercise date, or hopes to protect a long position in the asset. The advantage of buying a put over shorting the asset is that the risk is limited to the premium. The put writer does not believe the price of the underlier is likely to fall. The writer sells the put to collect the premium.
LEAPS
Given the plethora of opportunities that options allow, it is also important to know that there are options available which can be used to implement longer-term strategies.
These are called LEAPS (Long Term Equity Anticipation Securities) and are yet another alternative that options offer to investors.
LEAPS are publicly traded options contracts with expiration dates that are longer than one year. Structurally, LEAPS are no different than short-term options, but the later expiration dates offer the opportunity for long-term investors to gain exposure to prolonged price changes without needing to use a combination of shorter-term option contracts. The premiums for LEAPs are higher than for standard options in the same stock because the increased expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit.
LEAPS are an excellent way for a longer-term trader to gain exposure to a prolonged trend in a given security without having to roll several short-term contracts together. The ability to buy a call/put option that expires one or two years in the future is very alluring because it gives the holder exposure to the long-term price movement without the need to invest the larger amount of capital that would be required to own the underlying asset outright. These long-term options can be purchased not only for individual stocks, but also for equity indexes.
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