Everything you need to know about options

Options are derivatives, i.e. their price depends on an underlying, usually a stock. The global options market accounts for trillions of dollars, reason enough to take a closer look on the different types and styles of options. If you are new to options (and even if you are not), this article will help you understanding what options are, how they work, and which types we have to distinguish.

Distinction by type

Calls

By buying a call option (= long position) you obtain the right to buy an underlying asset (e.g. a stock) in the future at a specified price (so called strike price). Depending on the style of the contract, you can either exercise the option at any point in time prior to a specified expiration date or at the expiration date itself.

Long positions in call options are useful if you expect the price of the underlying to increase (but you don’t want to take the risk of a price decrease).

For example, assume the current price of MYM Inc. to be $100. You buy a call option that expires in 28 days, has a strike price of $100, and costs $2. Since you the have right (not the obligation) to exercise the option, your maximum loss is constituted by the price of the option (i.e. $2), while the maximum profit is, theoretically, infinite.

At the expiration date, MYM Inc. trades at $105. As this price exceeds the strike price of your call, you will exercise the option and buy the stock for $100. Your profit is then:

$105 (current price) – $100 (strike price at which you can buy the stock) -$2 (price of the option) = $3

Now assume the price of MYM Inc. to be $95. Given this situation ($95<$100), you are not going to exercise the call. While a stock investment would have led to a loss of $5, the loss of your call option is limited to the price of the option – in this case $2. Thus, the break even point is given by $102.

Conversely, one could also sell a call option (= short position). In case the buyer wants exercise the option, you have the obligation to sell the underlying asset at the specified strike price.

Thus, all of the above mentioned properties work the other way around, i.e. you gain $2 if the stock price decreases and lose money if the stock price increases (strike price – stock price + $2). Most importantly, since the buyer of the call option could theoretically earn infinite gains, the seller may incur infinite losses.


Puts

By buying a put option (= long position) you obtain the right to sell an underlying asset (e.g. a stock) in the future at a specified price. Depending on the style of the contract, you can either exercise the option at any point in time prior to a specified expiration date or at the expiration date itself.

Long positions in put options are useful if you expect the price of the underlying to decrease (but you don’t want to take the risk of a price increase).

Again, let’s assume the current price of MYM Inc. to be $100. You buy a put option that expires in 28 days, has a strike price of $100, and costs $2. Since you the have right (not the obligation) to exercise the put, your maximum loss is (again) constituted by the price of the option ($2), while the maximum profit is given by the current price of the stock. (Note that stocks have a minimum price of $0, whereas other underlyings, e.g. WTI oil, may display negative values.)

At the expiration date, MYM Inc. trades at $95. As this price is below the strike price of your put option, you are going to exercise the option and sell the stock for $100. Your profit is then:

$100 (strike price at which you can buy the stock) – $95 (current stock price) -$2 (price of the option) = $3

In contrast, each price above $100 would result in not exercising the put. For the above example, the break even point is given by $98.

Conversely, one could also sell a put option (= short position). In case the buyer wants to excercise the option, you have the obligation to buy the underlying asset at the specified strike price.

If you are the seller of the above put option, you will earn $2 if the stock price increases and lose money (stock price – strike price + $2) if the stock price increases.


Distinction by style

European

As mentioned above, each option has an expiration date (e.g. 28 days in the future) at which the buyer of a call (put) has the right to buy (sell) an underlying asset at a specified price. With respect to European options, you can only exercise your option at this specific date.

American

At a first glance, American options are very similar to European options. However, with American style options, the owner obtains the right to exercise the option at any time prior to the expiration date. Thus, American style options are at least as valuable as European options.


Distinction by market place

There are two ways to trade options:

  • Exchange Traded Options (also called listed options)
  • Over The Counter (OTC) options

While exchange traded options are listed on a public exchange (e.g. the Chicago Board Options Exchange, CBOE) and can be traded by anyone having access to a broker, OTC options are individually negotiated and less accessible to the public.


Distinction by the underlying

In addition to common stock options (underyling is a specific publically traded company), there are several options that depend on other types of underlyings (all explanations are related to a long position):

  • Currency (Forex) Options
    • The right to buy (call) or sell (put) a specific currency at a specific exchange rate.
  • Futures Options
    • The right to buy (call) or sell (put) a specific futures contract at a specific price.
  • Commodity Options
    • The right to buy (call) or sell (put) a specific commodity (e.g. WTI oil) at a specific price.
  • Index Options
    • The right to buy (call) or sell (put) a specific index at a specific price.


Further option types

Put and call options are by far the most traded options. However, there is a variety of further option types (most of them are traded over the counter):

  • Employee Stock Options (ESOs): ESOs are call options and granted to employees as part of an equity compensation plan. They give the right to buy the company’s stock at a specified price.
  • Cash Settled Options: Cash settled options don’t include a physical transfer of the underlying asset. Instead, they are settled through a monetary compensation.
  • Exotic Options
    • Barrier Options: Depending on the terms of contract, the holder either receives a pay-out if a specific (and pre-determined) price is reached or if it’s not reached.
    • Look Back Options allow to exercise at the best price the underlying reached during the contract.
    • Chooser Options allow the owner to choose whether the option is a put or a call.
    • Binary Options: Instead of the difference between the strike price and the price of the underlying, a holder of a binary option receives a fixed amount of money.

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