Options Defined
An option enables you to speculate on the movement
of individual shares, or of indices, currencies, commodities
or interest rates. It may be used for hedging.
Options may be traded over the counter (OTC) or on
exchange. The on-exchange options are cheaper because
they are standardized. They are tradable without counterparty
risk and are suitable for private investors.
Through an option, you have the right to buy or sell
a security at a predetermined price, the exercise
price, within a specified period. The market price
you will have paid for the right to exercise the option
is the premium, which is a small percentage of the
option’s size. It means the option is geared.
For every buyer of an option, there is a seller, also
known as a writer. On completion of your purchase,
you will pay an initial margin, which goes to the
writer and will cover the worst loss that could arise
in a day. You must keep this amount topped up on a
day-to-day basis where necessary to sustain the level
of cover. If you exercise the option, the writer must
provide the underlying financial instrument at the
exercise price. If you do not exercise it, the writer
will have your premium.
Calls and Puts
You may have bought a Call option, which gives you
the right, but not the obligation, to buy the underlying
security at the exercise price. If the asset price
is more than the exercise price of the option, the
difference represents the option’s value, and
the option is in the money. If the asset price is
less, the Call option is out of the money. If you
buy an option deep out of the money and the underlying
price moves a lot, the premium could move proportionately
in percentage terms but, in absolute terms, much less.
As owner of a Call option, you will make money only
if the price of the underlying stock or other financial
instrument rises above the exercise price plus the
premium that you paid (plus any dealing expenses).
In this case, the usual way to make money is to trade
your option at a profit.
You may have bought a Put option, which gives you
the right, but not the obligation, to sell a security
at the exercise price. If the exercise price is higher
than the underlying security’s current market
price, the option is in the money. If it is lower,
the option is out of the money. You will make a profit
if the option price falls to below the level of the
exercise price plus the premium that you have paid
(plus all dealing expenses).
Intrinsic and time value
Intrinsic value is how far the underlying stock’s
value is above the option’s exercise price,
in the case of a Call option, or below it in the case
of a Put option. An option has intrinsic value when
it is in the money.
The time value of an option is its total value less
intrinsic value. The more time an option has until
it expires, the higher this figure is likely to be
because the price of the underlying stock has proportionately
more of a chance of changing in the option buyer’s
favour.
The premium consists of both intrinsic and time value,
both of which can change constantly.
Shapes and sizes
Equity options come in the standard contract size
of 1,000 shares, although it may vary if the underlying
company is involved in a capital restructuring such
as a rights issue. To find the cost of an option contract,
multiply the option price by 1,000. If a Call option
is priced at 70p, it will cost £700 per contract.
The options traded on Euronext.liffe, the pan-European
exchange with a London presence, have expiry dates
grouped three, six or nine months ahead. When a contract
expires, for instance, in March, a new one is created
for expiry in June. A first group of companies on
Euronext.liffe has the expiry dates of January, April,
July and October; a second group has February, May,
August and November; and a third group expires in
March, June, September and December. In any given
month, options for only a third of all the companies
will expire.
Index options
Options on stock market indices, known as index options,
are contracts for difference. They typically trade
for larger amounts than equity options, perhaps several
thousand pounds per contract against several hundred
pounds, and they are more volatile. These factors
raise the risk/reward stake.
Interest rate options
Interest rate options enable traders to speculate
on, or hedge against, interest rate risk. The price
level of a contract is derived by subtracting the
interest rate from 100. An interest rate of 5 per
cent means that the contract price is 100 –-
5 = 95. Settlement is on a value per fraction of a
percentage change in interest rates. The more the
interest rate rises, the more the contract price declines,
and the reverse.
Commodities options
Commodities react differently from stocks or bonds
to market conditions and so to trade them is an excellent
way to diversify your investment portfolio. Options
are a good way to gain this exposure because they
specify the downside risk.
Hard commodities such as oil, copper and gold move
on a longer time frame than the soft commodities such
as cocoa and sugar, and exposure to a basket of commodities
provides its own diversification. You may achieve
this by buying an option on the Dow Jones AIG Commodity
Index, which trades 20 different commodities.
