Options trading 101
- Strike price: The strike price is the predefined price at which the underlying asset can be sold (put) or bought (call).
- Maturity: The maturity of an option contract is the date on which the option is exercised.
- Premium: The premium of an option is the price of the option.
What is an option?
An option is a contract that gives the holder the right (option), not the obligation, to buy or sell an asset at a predetermined price on a specified date. An option to sell the underlying asset is defined by the term put; an option to buy the underlying asset is defined by the term call. Buying a put is betting that the value of the underlying asset will decrease before the expiration date of the contract. Buying a call, on the other hand, is a bet that the value of the underlying asset will increase.
But what is an underlying asset? An underlying asset can be financial or non-financial in nature. The first options were used in Ancient Greece. They were based on the olive harvest. Today, the underlying asset can be a stock, an index, a bond, a currency, a futures contract or an agricultural or mineral commodity.
Imagine that stock A is trading at $25. You can buy a call at a premium of $1 with a strike price of $25 and a maturity of a month. The contract will cost $100, since an option contract covers 100 shares. Below is a graph of the value of a call versus the value of the stock. We can see that in order to make a profit, at maturity, the price of the stock must be greater than the sum of the strike price and the premium (26).
What is an exotic option?
There are several styles of options: American, European, Bermuda, Asian, etc… The major difference between these products is the type of exercise. American options can be exercised at any time prior to maturity, while European options can only be exercised at expiration and Bermuda options can only be exercised on certain dates prior to maturity. Compared to these three types of options where the payoff depends on the price of the underlying asset at a particular time, the payoff of Asian options, also known as average options, depends on the average price of the asset over a certain period of time.
An Asian option can be considered an exotic option. This type of option differs from traditional options in its payoff structure (how the payoff is determined), expiration dates, and strike price. Other types of exotic options are presented in the table below.
A compound option is a derivative product where the underlying asset is another option. We could buy the put of a put, the call of a put, the put of a call or even the call of a call.
A binary option differs in its payout structure. It pays a gain if an event occurs or an asset reaches a certain value at maturity. A bet on the weather can be made through this type of option.
A basket option is similar to a traditional option however, it is not based on a single underlying asset, but several. Depending on the characteristics of the option, the assets in the basket may or may not be equally weighted.
How do I get options?
Derivative products such as options are traded in many markets. Not far from here, in downtown Montreal, derivatives such as options on stocks, indices, currencies, ETFs, energy, and interest rates are traded on the Montreal Exchange. Other exchanges of this type exist, such as the Chicago Board Options Exchange or the Boston Stock Exchange. As with the stock market (TSX, NYSE), you must go through an agent to buy/sell options. Various platforms offer the possibility to trade stock options:
- CIBC Investor’s Edge
- TD Direct Investing
- RBC Direct Investing
- Online brokerage (Desjardins)
Another way to get options is through compensations between an employee and his employer. While some companies will offer shares of the company directly to their employees, others will distribute calls. Called Employee Stock Options (ESO), they allow the employee to buy shares of the company at a given price for a given period.
Abraham, S. A. (2021, September 21). The history of options contracts. Investopedia. Retrieved November 19, 2021, from https://www.investopedia.com/articles/optioninvestor/10/history-options-futures.asp.
Chen, J. (2021, November 17). How options work for buyers and sellers. Investopedia. Retrieved November 19, 2021, from https://www.investopedia.com/terms/o/option.asp.
Dhir, R. (2021, November 19). How a put works. Investopedia. Retrieved November 19, 2021, from https://www.investopedia.com/terms/p/put.asp.
Fernando, J. (2021, November 19). Strike price definition. Investopedia. Retrieved November 19, 2021, from https://www.investopedia.com/terms/s/strikeprice.asp.
Chen, J. (2021, September 13). What is an Asian option? Investopedia. Retrieved November 19, 2021, from https://www.investopedia.com/terms/a/asianoption.asp.
Chen, J. (2021, November 19). Exotic option definition. Investopedia. Retrieved November 19, 2021, from https://www.investopedia.com/terms/e/exoticoption.asp.