Options - the basics

In response to a query, I have set out a basic summary of options. The next post will discuss the role which options play in the private portfolio.

How they work

Options are contracts which give one person the right (but not the obligation) to buy (sell) an underlying asset at some point in the future at a price which is fixed at the time the contract is entered into (called the "strike price"). The seller of the option (referred to as the "writer") has the obligation to sell (buy) the underlying asset at the agreed price if and when the buyer exercises the option.

The buyer will only exercise the option if the underlying asset is worth more than the agreed strike price at the time of exercise. If the underlying asset is worth less than the strike price at the time of exercise, the buyer will not exercise the option. At the time the option contract is entered into the buyer will pay the seller a sum of money in exchange for these rights (called the "premium"). The seller gets to keep the premium regardless of whether the option is exercised or not.

Terminology and variations

Call option: the right given to the buyer is a right to buy the underlying asset

Put option: the right given to the buyer is a right to sell the underlying asset

Exchange traded options: the options are traded on a stock exchange. These options will typically allow for buyers and sellers to close their position prior to expiry/exercise by entering into an opposite contract

Over the counter (OTC) options: the options are not traded and represent a private contract between the buyer and seller. Typically it is not possible to unilaterally close out an OTC contract before exercise/expiry

Expiry: options have an expiry date. If they are not exercised or closed out before the expiry date, they lapse. Some cash settled options may exercise automatically if they are in the money on the expiry date

Settlement: on exercise, options may be physically settled or cash settled. Physically settled options will result in the underlying asset being delivered against payment of the strike price. Cash settled options are not settled by delivery of the underlying asset but by payment of the difference between the strike price and the market price at the time of exercise (if this is negative then no payment is made)

American style/European style: an American style option can be exercised at any time prior to expiry. A European style option can only be exercised on the expiry date. Most exchange traded options are American style. Most OTC options are European style

Collateral: sellers (writers) incur future liability. OTC counter parties and stock exchanges which offer exchange traded options will require a person writing options to post collateral before allowing the option to be delivered

Underlying: the asset which is the subject of the option. Underlying may be shares, ETFs, bonds, commodities, currencies or intangibles such as indexes

Premium: the amount paid by the buyer to the seller in exchange for the future right to buy (or sell) the underlying. The seller gets to keep the premium regardless of whether the option is exercised. The size of the premium will depend upon (among other factors), the difference between the market price and the strike price, the volatility of the underlying, interest rates and the time left until expiry (duration)

Strike price: the price agreed today at which the option may be exercised in the future. The strike price may be above, at or below the current market price

Covered option: an option where the seller holds the underlying asset

Naked option: an option where the seller does not hold the underlying asset

Next up - what I use options for and why.