Options
Options are one of the more difficult financial instruments to understand. Therefore, we have created this beginner’s guide to explain what options are, how they are traded and what benefits and risks they present to the investor.
What is an option?
An option gives you the right, but not the obligation to either buy or sell an asset at a certain price on a certain date.
An example:
If you have a contract stating that you can buy my car on June 1st at the price of USD 1,000, you have an option – an option to buy my car. If the value of my car is higher than USD 1,000 on June 1st, you will profit from buying it because you can then turn around and sell it for more than USD 1,000. On the other hand, if the price were less than USD 1,000, you would not want to buy my car. Since an option gives you the right but not the obligation to either buy or sell an asset, you are entitled not to buy my car if the price does not suit you.
Options Terminology
Call option When you have the right to buy an asset you have a Call option. This type of option is the kind you had in the car example above.
Put option When you have the right to sell an asset, you have a Put option.
If you buy the right to sell me your car for USD 1,000, you have bought a put option and you will sell it to me if the market price is less than USD 1,000. If the market price is more than USD 1,000, the option is worthless to you and you won’t use it. Because you have bought from me the right to sell me the car, I am forced to buy it from you if you wish to sell.
Strike price
The strike price is the price at which the underlying asset is either sold or bought if the option is exercised. The strike price is also called the exercise price.
In our example above, the exercise price was USD1,000.
Premium
The premium is used in two different contexts. The premium can be
a) the total price of the option or
b) the amount by which the price of the option exceeds its intrinsic value.
The latter definition is also known as the option’s time value. When you buy an option, you pay a premium up front, entitling you to the opportunity to profit from a price change in the underlying asset. Your potential loss is limited to the premium, but you still have an unlimited profit potential.
Since you have a profit potential in owning an option on my car, I don’t give the option to you for free. Its costs you a premium, the amount of which depends on the profit potential you have. We will return to this profit potential later.
xyz Bank quotes option premium in the secondary currency. If you are quoted a premium of 0.60 / 0.70 for USD/JPY, the premium to purchase options for the notional amount of USDJPY x 0.70 = JPY. In this example, to buy a Call option for 10,000 USDJPY, you would pay a premium of 7,000 JPY.
Expiration date
The expiration date is the day on which the option expires. xyz Bank supports European options that can only be exercised on the expiration date.
In our example, if the Call option on the car for USD 1,000 is a European option and June 1 is our expiration date – June 1 is the only date when the option can be exercised. The option is only worth anything on that date if the market price exceeds the option strike price of USD 1,000.
Exercise
You exercise an option when you invoke the right to purchase or sell the underlying asset at the price stated in the option contract. Options are only exercised.
Exercise procedure
The time of exercise is 16.00 P.M. CET on the day of expiry and it is done automatically. The spot price at the time of exercise determines whether the option contract is exercised. When an option is exercised that is ‘in the money’, it is converted to an actual spot position and at the risk of profit/loss if spot moves. If you already have an offsetting position, it will then be netted out at the next day’s validation.
Volatility
There are two types of volatility:
1) Historical volatility is actual volatility based on volatility realized in past movements in the market.
2) Implied volatility is the volatility interpreted from the price of options. So, the implied volatility is the expected spread of movement of an underlying asset’s price predicted over the term of the option derived from the known prices of options and the other parameters used in the calculation of those prices.
