Options

What are options?
An option is a legally binding contract that gives the buyer the right but not the obligation to buy(or sell) a pre-determined asset at a pre-determined price on a pre-determined date. For example, a call option on 1 Google share with strike price of $500 expiring on 22^nd June, 2009 gives the buyer the right to buy 1 Google share at the price of $500 on 22^nd June, 2009.

Terminology
Strike Price: The pre-determined price at which the option buyer can buy (or sell) the underlying asset at the pre-determined date.

Expiry Date: The pre-determined date on or before which the option buyer can buy (or sell) the underlying asset at the strike price.

Exercise: The process by which the option buyer “exercises” his right to buy (or sell) the underlying asset on or before the expiry date, thereby taking delivery of the underlying asset.

American option: The type of option which gives the buyer the right to exercise it anytime on or before the expiry date.

European option: The type of option which gives the buyer the right to exercise it only on the expiry date.

Option premium: The price of the option, i.e. the amount of money that the option buyer has to pay the seller in order to buy the option.

In the money: If the exercise of an option would result in a profit at that particular moment, it is said to be “in the money” at that moment.

Out of the money: If the exercise of an option would not result in a profit at that particular moment, it is said to be “out of the money” at that moment.

Types of Options
There are two main types of options are:

1. Call Options: Call options give the buyer the right but not the obligation to buy the underlying asset at a pre-determined price on a pre-determined date.

2. Put Options: Put options give the buyer the right but not the obligation to sell the underlying asset at a pre-determined price on a pre-determined date.

Modalities
Options give investors leverage as they expose investors to large possible changes in the value of their position with small amounts of initial capital. Leverage serves to multiply gains as well as losses.

For example, in order to gain exposure to the movement in price of 1000 shares of PQR Corp, trading at $10 per share, an investor could spend $10,000 and buy 1000 shares. A 10% increase in the share price of PQR (to $110 per share) would give him a profit of $1000, i.e. 10% of his initial investment. This is the traditional way of investing.

However, if the same investor were to buy an American style call option with strike price $10 and 1 month to expiry, he would only have to pay the option premium which is say, $0.5 per option i.e. a total of $500. The same 10% increase in price of the underlying shares (to $110 per share) would make it attractive for him to exercise his options. He could exercise his options and receive 1000 shares of PQR Corp at $10 per share, paying $10,000. He could then sell these shares in the open market at $110 per share (current market price), thereby making a profit of $1000. This is 200% of his initial investment (of $500).

Fortunately, this is not true even for losses. A 10% fall in the price of the underlying shares would ensure that it is unattractive for the option buyer to exercise his option. Why buy 1 share of PQR Corp at $100 when it is available in the open market for $90? The investor would allow his option to expire, worthless. This however, means that he would lose the option premium paid. Thus, the maximum amount that an option buyer can lose is the option premium.

The option seller however, has an unlimited downside. If the option were to be exercised, he would have to deliver the underlying shares at the pre-determined price (call option) even if it means buying shares in the open market and delivering them at a loss. The option seller is rewarded for taking this risk in the form of the option premium.

How are options traded?
Like futures, options too are traded on exchanges. The exchange regulates the trade of options and acts as the counterparty to both the buyers and the sellers. The major difference between futures and options in this regard is that options on the same underlying asset can have different strike prices unlike futures where the price is market determined.

Advantages

1. Options give their buyers leverage. Hence, they gain exposure to large price movements with limited amounts of capital thereby making them excellent tools for speculators.
2. Options are good ways to hedge exposure to the underlying asset price movement.

Disadvantages

1. Options expire on the expiry date. Hence is possible for option buyers to lose their entire investment if their options expire out of the money.

2. Option sellers have an unlimited downside and can lose more money than the premium they receive.

Exotic Options
We have only examined basic options in this article. Complex and exotic options such as Barrier options, Digital options, Bermudan style options, James Bond style options exist and are popular with institutional investors. These shall be examined in another article.

Next: Asset Allocation