A stock option gives the holder the right, but not the obligation, to purchase (or sell) 100 shares of a particular underlying stock at a specified strike price on or before the option’s expiration date. There are two kinds of options: American and European. American options differ from European options in that European options allow the holder to exercise only on the expiration date.
How it works:
All options are derivative instruments, meaning that their prices are derived from the price of another security. More specifically, options prices are derived from the price of an underlying stock. For example, let’s say you purchase a call option on shares of Intel (Nasdaq: INTC(link is external))with a strike price of $40 and an expiration date of April 16. This option gives you the right to purchase 100 shares of Intel at a price of $40 on or before April 16th (the right to do this, of course, will only be valuable if Intel is trading above $40 per share at that point in time).
Every option represents a contract between a buyer and seller. The seller (writer) has the obligation to either buy or sell stock (depending on what type of option he or she sold–either a call option or a put option) to the buyer at a specified price by a specified date. Meanwhile, the buyer of an options contract has the right, but not the obligation, to complete the transaction on or before a specified date. When an option expires, if it is not in the buyer’s best interest to exercise the option, then he or she is not obligated to do anything. The buyer has purchased the option to carry out a certain transaction in the future — hence the name.
As a quick example of how call options make money, let’s say IBM (NYSE: IBM(link is external)) stock is currently trading at $100 per share. Now let’s say an investor purchases one call option contract on IBM at a price of $2 per contract. Note: Because each options contract represents an interest in 100 underlying shares of stock, the actual cost of this option will be $200 (100 shares x $2 = $200). This American contract happens to say the investor can purchase up to 100 shares for $100 each on or before January 1.
Here’s what will happen to the value of this call option under different scenarios:
When the option expires, IBM is trading at $105.
Remember: The American call option gives the buyer the right to purchase shares of IBM at $100 per share on or before January 1 (rather than only on January 1, as would be the case with a European option). The buyer could use the option to purchase those shares at $100, then immediately sell those same shares in the open market for $105. This option is therefore called “in the money.” Because of this, the option will sell for $5 (because each option represents an interest in 100 underlying shares, this will amount to a total sale price of $500). Because the investor purchased this option for $200, the net profit to the buyer from this trade will be $300.
When the option expires, IBM is trading at $101.
Using the same analysis, the call option is worth $1 (or $100 total). Because the investor spent $200 to purchase the option, he or she will show a net loss of $1 (or $100 total). This option is called “at the money,” because the transaction is essentially a wash.
When the option expires, IBM is trading at or below $100.
If IBM ends up at or below $100 on the option’s expiration date, then the contract will expire “out of the money.” It will now be worthless, so the option buyer will lose 100% of his or her money (in this case, the full $200 that he or she spent for the option).
The Black Scholes model is a formula used to assign prices to option contracts, but it is geared toward European options. American options command higher prices than European options because the American options essentially allow the investor several chances to capture profits, whereas the European options allow the investor only one chance to capture profits
Why it Matters:
Investors use options for two primary reasons — to speculate and to hedge risk. To speculate is to simply bet on the direction of price changes. Hedging, however, is like buying insurance — it is protection against unforeseen events. Using options to hedge your portfolio accomplishes this for some investors.
In general, European options are riskier than American options because they allow only one day of exercise opportunity to the investor. American options give the underlying stock more chances on which to rise enough to put the option in the money. For sellers of European option contracts, this all can be an advantage.
Many index options are European options, so investors should be sure to understand the nature of what they’re buying.
Introduced in 1981, index options are call or put options on a financial index comprising many stocks.
How it works (Example):
Index options usually have a contract multiplier of $100, meaning that the price of an index option equals the quoted premium times $100. Unlike options in shares of stock or even commodities, it’s not possible to physically deliver the underlying index to the purchaser of an index option. Thus, index options settle via cash payments.
Many times it is in an investor’s best interest to lock in recent gains or to protect a portfolio of stocks from a decline beyond a certain price. One way to do this would be to purchase a put option contract on each of your various holdings (this would essentially allow you to “lock in” a particular sale price on each stock, so even if the market crashed, your overall portfolio wouldn’t suffer much). However, if you hold a large, diversified portfolio of stocks, then it is probably not cost-effective to insure each and every position in this manner.
As an alternative, investors might want to consider using index options to hedge the risk in their portfolios. Many different indices have options available, including the Nasdaq 100, the Dow Jones Industrial Average and the S&P 500. With some careful planning, investors should be able to offset a sharp decline in a portfolio by hedge their overall position with index options. Though it is impossible to forecast exactly how a portfolio will perform during a steep market sell-off, one can get fairly close to the actual result by determining which particular index to use as a proxy for the portfolio and then determining the correct number of options to use as a portfolio hedge.
Why it Matters:
Index options are essentially bets on the overall movement of the market or a basket of stocks. Hedgers and speculators can use them to get exposure to an entire market or entire sector in a single, quick transaction. And like other options, index options offer leverage and predetermined risk. After all, the most the index option trader can lose is the premium he or she paid to hold the options, and the upside can be incredible.
It is important to note that equity index options have special tax consequences: 60% of any gain on the sale of the option is taxed as a long-term capital gain; the other 40% is taxes as short-term capital gain income.
A currency option is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller, the amount of which varies depending on the number of contracts if the option is bought on an exchange, or on the nominal amount of the option if it is done on the over-the-counter market. Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.
Investors can hedge against foreign currency risk by purchasing a currency put or call. There are two main types of options, calls and puts:
Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ”writing” an option.
Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. Put buyers – those who hold a “long” – put are either speculative buyers looking for leverage or “insurance” buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a “short” expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlying is at or above the option’s strike price at expiration. The maximum loss is unlimited for an uncovered put writer.
Options pricing has several components. The strike is the rate at which the owner of the option is able to buy the currency if the investor is long a call, or sell it if the investor is long a put. At the expiration date of the option, which is sometimes referred to as the maturity date, the strike price is compared to the then-current spot rate. Depending on the type of option and where the spot rate is trading, in relation to the strike, the option is exercised or expires worthless. If the option expires in the money, the currency option is cash settled. If the option expires out of the money, it expires worthless.
A contract permitting the option buyer the right, without obligation, to buy or sell an underlying asset in the form of a commodity, such as precious metals, oil, or agricultural products, at a designated price until a designated date.