Options – an introduction

In finance, options are a type of derivatives that gives the holder a right but not any obligation to carry out a certain transaction on the terms stated in the option’s term sheet.

What is the difference between a call option and a put option?

The call option gives its holder (owner) the right to buy the underlying asset or instrument for a pre-specified price.

The put option gives its holder (owner) the right to sell the underlying asset or instrument for a pre-specified price.

The pre-agreed price is known as the strike price, for both call options and put options.

Options are created for a lot of different underlying assets or instruments, including commodities, stocks, bonds, currency, and futures contracts.

The writer

So, I have purchased an option that gives me the right to buy 100 shares in Norwegian Cruise Line Holdings (NCLH) for the strike price. Who is obliged to sell me these shares? That would be the writer, i.e. the creator of the option.

 

The writer creates and option and sells it. The option can then be sold and change hands many times before it expires. The writer of the option has the same duty to anyone who is the current owner of the option.

The premium

The price you pay when you purchase an option is the premium. Not to be confused with the strike price, which is the pre-agreed price for the underlying asset or instrument.

When can I exercise the option?

If you elect to use your option, e.g. to sell the underlying (put option) or buy the underlying (call option) this is known as exercising the option.

When you can exercise the option depends on what type of option you have. You will find information about this in the term sheet for the option.

The two most commonly traded types of options are European-style options and American-style options. A European option can only be exercised on its expiration date. An American-style option can be exercised on any day until it has expired. You therefore get a much higher degree of flexibility with an American-style option.

Options that aren’t European-style nor American-style are referred to as exotic options. There are for instance options that can only be exercised on a few particular dates during the life time of the option, as outlined in the term sheet.

Option trading

Options are traded on exchanges and over the counter (OTC). The options that are traded on exchanges are highly standardized, while options traded OTC can be anywhere from highly standardized to completely tailor-made for a specific purpose.

Examples of option types commonly traded on exchanges are stock options, futures contracts options, callable bull/bear contract options, stock market index options, and bond options. Currency cross rate options and swaptions are on the other hand rarely listed on exchanges.

Trading employee stock options?

Please note that employee stock options often contain special provisions that make it impossible for these options to be exercised by anyone else than the employee who received the stock options.

Exchange-traded options

As mentioned above, exchange-traded options are highly standardized. Ticker symbols are used, just as for exchange-traded company shares.

Exchanges typically do various things to mitigate risk for the traders and encourage them to use the exchange instead of trading OTC.

  • Exchanges are subjected to national law and regulations, but each exchange will also have its own even stricter set of regulations to mitigate risk for the traders. The exchange can enforce its own rules without having to drag the issue through court.
  • Exchange-traded options are typically (but not always) backed by the credit of the exchange, to add an extra layer of security for the traders.
  • Exchange-traded options are settled through a clearing-house. Clearing-houses require collateral from the writers (creators) of options. Many clearing-houses also have a guarantee fund to use if an option writer fails to fulfil obligations to an option holder.

Term sheet

The term sheet is where you find detailed and important information about the option, such as the settlement terms and the terms by which the option is quoted in the market.

Examples of things that you should make sure that you know before you purchase any option:

Info Example
The underlying asset or instrument Expedia Inc common stock (NASDAQ: EXPE )
The quantity of the underlying asset or instrument 200 shares
Is it a call option or a put option? Put
The strike price 119.00 USD per share
Type of option American-Style
Expiration date January 31, 2019
Settlement terms Cash-settled
The writer Goldman Sachs