An option is a financial derivative that represents a contract sold by one party (the writer) to another party (the holder), giving the holder a right but not an obligation to carry out a specified transaction until or on a specific date in the future. Until the option has expired, the current holder can sell the option to someone else, who then becomes the new options holder.
If one wants to create a contract that gives the holder both a right and an obligation to carry out the transaction, there are other financial instruments to chose among, such as futures. Options never impose any obligation on the holder. The writer of an option has an obligation, but not a right, to carry out the transaction.
If the holder of an option decides to carry out the transaction, this is called exercising the option. Today, it is very common for options to be exercised without any underlying asset actually being bought and sold. Instead, the option writer pays the option holder the difference between the strike price and the current market price in cash.
American-style options can be exercised at any time until the option expires. European-style options can only be exercised on the expiry date. There are also other options available, e.g. Bermuda-style options.
One popular type of option that sets itself apart from other types of options is the binary option. Binary options can only be traded within the platforms of special binary option brokers. They can not be traded on the upon market and do not have any value outside the brokers platform. Binary options are used to speculated on the market and can not be sold or traded once they have been purchased. You will have to wait until they mature. At that point they will give you a high return (often 70-80%) if they mature in the money. If they mature outside the money they are worthless and you have lost the purchase price of the option.
Example
The writer creates an option that gives the holder the right, but not the obligation, to purchase 100 shares in Apple Inc. for 120 USD/ share on December 1st this year.
- This is a call option, since it gives the holder a right to buy something. An option that gives the holder the right to sell something is a put option.
- The price you pay when you purchase an option is called premium.
- The 120 USD/share is the strike price.
- 100 shares in Apple Inc is the underlying asset of this option.
- December 1st this year is the expiration date. Some options can only be exercised on a specific date, others can be exercised on any date until they expire, and there are also options that can be exercised on certain specified dates only.
On December 1st, the market price for Apple Inc is 125 USD/share. The option holder elects to exercise the option. According to rules stipulated in the options contract, the option writer doesn’t have to deliver 100 Apple Inc shares. Instead, the writer fulfills their obligation by paying the options holder $500 in cash.
Market price: 125 USD x 100 shares = 12,500 USD
Strike price: 120 USD x 100 shares = 12,000 USD
Understanding the options symbol
To make options trading easier and more efficient, exchange traded options are labeled with a standardized option symbol.
Earlier, the option symbol was just five letters, before being increased to six letters. Then, in 2010, the Options Clearing Corporation pushed through an industry-wide change to 21 character option symbols. These new 21 character symbols contain both letters and numbers.
The 21 character option symbol consists of four parts.
Part one: Root symbol of the underlying stock or exchange traded fund, padded with spaces to 6 characters
Part two: Expiration date, in the six number year-month-day format (YYMMDD)
Part three: Option type. P = put option. C = call option.
Part four: Strike price, given as the price x 1000, front padded with 0s to 8 digits
Example
Let’s take a look at the option symbol LAMR 170530P00062500
- Part one: LAMR
LAMR is the root symbol of A-shares in Lamar Advertising Company, a company listed on NASDAQ.
- Part two: 170530
The expiration date for this option is May 30, 2017
16 = the year 2016
05 = the month of May
30 = day 30 in the expiration month
- Part three: P
The letter P tells us that this is a put option.
- Part four: 00019500
The last eight digits will tell you the strike price. For this option, the strike price is 62.50 USD. The extra zeros are only there as padding, to bring the number of digits up to eight.
Open Interest
For an option, the open interest is the number of open contracts (either puts or calls) that have not been exercised, closed or expired. Open interest show the total number of open options that exists on a given day.
The number of open contracts on the options market tend to change from day to day. The number changes each time a new contract is created or an existing contract is exercised / closed / expired.
Traders are interested in known the open interest number since it indicates the flow of money into the options market. An increase is typically interpreted as a bullish signal and an indication that more money is flowing into the options market than before. A drop in open interest will typically be interpreted as a bearish signal and an indication that less money is flowing into the options market than before.
Technical analysts will also use open interest as a momentum indicator of trend strength. Increasing open interest is seen as an indication of increased momentum for the current market trend. Increased momentum is seen as a sign of this market tend being likely to continue rather than reverse.
Fair Value
An option’s fair value is simply its value at a certain date.
Examples of factors that can impact the fair value of an option:
- The date for which the fair value is established
- The option’s expiration date
- Is it a put option or a call option?
- Is it a European-style option, American-style option, or something else?
- Strike price
- Market price of the underlying
- Volatility of the underlying
Black Sholes Model
This model is often used for the valuation of European-style options.
Binominal model
This model is often used for the valuation of American-style options.
This article was last updated on: October 11, 2016