Module 15 – Options

Introduction

Unlike any other trading derivative, options give you choices. If you trade in futures, contracts for difference, spread betting or any other financial derivative (a financial instrument that ‘derives’ its value from something else), you can leverage your money but you are also committed to the downside.

With options you can have a limited downside, and just walk away, regardless of what the underlying financial security may be doing. The limited downside is the price or premium you pay for having a choice, but as long as you are buying an option your costs end there.

There are some very creative ways that you can combine options or use them in other financial instruments for specific purposes, and we’ll look at some of them in the strategy section.

What Is an Option?

An option gives you the right but not the obligation to buy or sell a specific security at an agreed price by a certain date. There are two types of options, calls and puts. If you buy a call option you have the right, but not the obligation, to buy a specific security at the agreed price, and if you buy a put option you have the right, but not the obligation, to sell a specific security at the agreed price.

I’ve emphasized ‘right, but not the obligation’ as this is key to an option. If the position you have bought the right to won’t make you money, you don’t have to do anything with it — it’ll just expire worthless on the certain date. You will have paid for the option when you first took it out, but that is the limit of your liability.

There are set expiration dates, just as with futures, and options expire on the third Friday of the month named. Unlike futures, you have a selection of options available for each contract month, as you can choose the amount named in the option. This is called the “strike price” or “exercise price”.

Because of this, options can be ‘in the money’, ‘at the money’, or ‘out of the money’. If options are in the money, they are worth ‘exercising’ or taking up; if an option is at the money, that means the strike price is the same as the current market price; if an option is out of the money, then it’s not (at present) going to be worth taking up or exercising, and if things don’t change, it will expire worthless.

Just as with futures, options can be readily traded because they are standardized. They go through an exchange, which guarantees the performance, and you are limited to the strike prices that are quoted. Options on shares usually end with physical delivery, that is you buy or sell shares of the underlying stock if the option is exercised; options on indices are cash settled.

As you can imagine, all these choices of strike price and expiration date mean that there are a range of prices, or premiums, for each combination, even for the same share. Each option you buy is for 100 shares. Here’s a screen from the CBOE (Chicago Board Options Exchange), showing a few of the options on Abercrombie & Fitch.

abercrombie-fitch

The strike price is each blue identifier, with the call prices on the left and the puts on the right. These prices are per share, so the option costs 100 times the quote. You can see that the further the calls are in the money, the more they cost, as you would expect. This is called an options chain, and you are limited to the prices that are quoted. Note that this is only a small part of the options available, as this is just the close priced options for May and June.

You can see that there are Bid and Ask prices for each of the options. You can buy at the Ask, and then the only number that matters to you is the Bid, which is the price you can sell it at. You have to make up the difference between the two prices before you make a profit, and that difference is called the spread.

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