Ahh, derivatives. You either love em’ or you hate em’; and, no, I’m not talking about the scary math kind. I’m talking about the fascinating financial instruments whose prices are dependent upon (AKA derived from) an underlying asset(s). What this means is that a derivative instrument’s price changes in relation to the value of something else, so if that “something” changes in value, the price of the derivative will change as well. This article will focus specifically on options contracts (at an introductory level), which derive their value from the price of an underlying equity security, but will be a part of a series of articles that are focused on options, as well as other derivative instruments. First, let’s talk about the Tale of Two Traders.
An options contract is an agreement between two parties in which the writer (seller), let’s call him Walter, of the option gives the buyer, or Billy, the right to enter into a transaction with the writer in the future. The transaction is for a specific asset, at a specific price, and within a specific time period (or on a specific date), but the contract does not obligate the buyer to initiate the transaction, hence the term “option.” An alternate way to think of it, outside of the the realm of finance, is like a sale at a store: the store is offering a limited-time sale for all to take advantage of, but you, as a consumer, are not forced to buy anything. In this instance, the store is the writer and you are the (potential) buyer, and the underlying asset is the collection of products at the store.
Much like sales at a store, options contracts can only be initiated by the buyer for a certain set period of time, before they expire. For simplicity purposes, let’s focus on two different types of option “expiration types”: American expiration (called American options) or European expiration (called European options). American options can be exercised at any point throughout the contract period, up to, and including, the expiration date. European options, on the other hand can only be exercised on the expiration date, which is usually the third Friday of the month specified in the contract (same goes for American options).
Speaking of the contract stipulations, let’s take a look at what an equity option contract looks like. As I mentioned above, an option contract specifies the asset, the price, and the time, but how does it do that? Below you’ll see a simplified American option ticker for the common stock of a fake company, XYZ Corporation. The main goal of an option ticker is to be as descriptive as possibly using the least amount of space, so each an every letter in the ticker is to be carefully noted.
The beginning of the option ticker is the symbol of the underlying asset so that investors know ‘what they’re getting themselves into.’ The next three letters are the month in which the option contract expires, in Billy’s case the option expires in November. But, how do we know if it’s November 2016, or 2017, or even 2023? Well, regular options are traded with expirations of up-to one year. In order to have an option contract with more than one year until expiration you would have to buy Long-Term Equity Anticipation Securities, or LEAPS, which allow an investor to take advantage of price movements in the underlying asset over a long period of time without having to buy multiple contracts.
Going back to our option, this means that Billy has until the third Friday of November to execute the option, but what does executing the option mean? Not only are there two sides of the transaction, but there are two types of transactions that could occur for an equity option: a call option or a put option; the type of transaction is specified by the fourth component of the ticker, after the strike price (which we will address shortly). A call option is a right to buy the underlying asset, while a put option is a right to sell the underlying asset. A way to remember the difference is that a call option is Billy’s right to ‘call upon’ Walter to buy the security from him. A put option can be remembered that by thinking of it as the Billy’s right to put the underlying asset into Walter’s hands. Now, if a person has the right to do something, that means someone else has the obligation to make that right possible. Therefore, Walter has the obligation to buy or sell the underlying asset if Billy chooses to exercise the right.
If you take a moment to ponder these types of options, think about why Billy would want to have the right to buy or sell to Walter, who is obligated to sell or buy, respectively. Before you wrack your brain too much, remember that the option contract specifies the price at which the transaction takes place. That’s to say, the price that the underlying security is bought or sold at (the number after the expiration month) is specified much before the transaction actually takes place. So, returning to the question at hand: Billy would want the right to buy the security at a pre-defined price if the security has gone up in price, and vice-versa when he wants the right to sell an asset. Thus, a person who buys a call option (buying the right to sell) believes that the underlying security’s price will rise, and the buyer of a put option (buying the right to sell) believes the price will decrease.
The last component of the ticker is the option premium, or the price that is paid to buy an option. The last paragraph explores the transaction from the buyer’s side, but the option premium is the ordeal from the perspective of the writer. The option premium is the price that the buyer pays the writer in order to enter into the contract, whether or not they choose to execute their right to buy or sell. While the buyer can profit from large (favorable) moves in the stock price, in relation to their option position, the writer only profits a set amount (the premium) when the stock price moves unfavorably for the buyer. That is to say, if Walter were to write a call, he profits when the stock price falls. If Walter were to write a put, he profits when the price rises. This is because, for example, if XYZ falls to $28 per share, Billy would not execute the call option since he would lose money. The opposite idea applies to put options. Therefore, Walter would not have to fulfill his obligation, will not lose money, and will not have to ‘forfeit’ his premium of “3.” Since options contracts (typically) allow you control 100 shares of the underlying equity asset per contract, and his premium is 3, or $3 per share, Walter walks away from the deal with a nice $300 profit.
Here’s a table (using bull and bear terminology) to simplify the above idea:
So, we’ve got two traders, Walter and Billy, trading at odds with one another. How can they manage to make a pretty penny? What techniques should they use, and how would they know that they’ll be successful? For that discussion, we’ll wait until another day. For now, let’s just be thankful that they aren’t launching another French Revolution…