An Options contract, just like a company share or bonds, is a form of Security, having a binding contract with strictly defined terms and properties. This contract gives the buyer the right to buy or sell the asset at a specific price on or before a certain date, but without the obligation to do so.
The principle behind an options contract is present in many everyday situations. For example, say that you find a house that you’d love to buy. However, you don’t have the cash to buy it right now. You have another property to sell, which will take another three months. The owner and you negotiate a deal that gives you the option to buy the house in three months time for a price of (say) £250,000. For agreeing to this deal (option), you pay the owner a fee of £3,000.
Now, consider these two possibilities:
- Doing your “due diligence” you discover that the house is actually the true birthplace of T. E Lawrence (Lawrence of Arabia) As a consequence, the market value of the house surges to £1 million. As the present owner sold you the option, he is obligated to sell you the house for £250,000. Meaning that you stand to make a gain of £747,000 (£1 million – £250,000 – £3,000). On the other hand…
- While inspecting the house, your surveyor finds the walls are full of asbestos, that a ghost haunts the master bedroom and a colony of termites have infested the cellar. Although you originally thought that you had found the home of your dreams, you now consider it not to your liking. However, because you bought an option, you are under no obligation to go through with the purchase. Of course, you lose the £3,000 you paid for the option.
These two possibilities demonstrate two important aspects.
- First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiry date go by, at which point the option becomes worthless. If this happens, you lose the money you used to pay for the option.
- Second, an option is a contract that only deals with an underlying asset. In financial terms Options are known as “derivatives“, because they derive their value from something-else.
A Call Option gives the holder the right to buy an asset at a given price within a specified time. Buyers of a Call hope that the underlying asset will increase substantially before the option expires (also known as a “Long Position”).
A Put Option gives the holder the right to sell an asset at a given price within a specified time. Buyers of a Put hope that the price of the stock will fall significantly before the option expires (also known as a “Short Position”).
It can be seen then that there are four types of participant in an Options Market, those that want to;
- Buy a Call
- Sell a Call
- Buy a Put
- Sell a Put
People who buy options are known as “Holders” and those who sell options are known as “Writers“. As above, buyers are said to have a “long position” and sellers are said to have a “short position”.
The important difference between buyers and sellers is that;
- The Holders of Calls and Puts are not obliged to buy or sell. They may do so if the wish.
- The Writers of Calls and Puts are obliged to buy or sell. Which means, of course, that they may be required to make good on that promise to buy or sell.
If that seems confusing at first… it is.
So in this series we are going to look at options from the view of the Holder (buyer). Selling options is more complicated and can be even riskier. For the purpose of Options Domination it’s sufficient to understand that there are two sides of an options contract.
With or without the Options Domination programme, it’s useful to know the terminology associated with the options market.
The price at which an underlying stock can be purchased or sold is called the “strike price“. This is the price a stock price must go above (for calls) or go below (for puts) for a position to be activated (or exercised) for a profit. All of this must occur before the expiry time (Expiration Date) – which may be minutes, hours or even days.
An option that is traded on an options house such as LIFFE ( The London Financial Futures and Options Exchange) is known as a listed option. These have fixed strike prices and expiry dates. Each listed option represents 100 shares of company stock, called a “contract“.
For call options, the option is said to be in the money if the share price is above the strike price. A put option is in the money when the share price is below the strike price. The amount by which an option is in the money is known as its intrinsic value.
Because of all these factors, determining the premium of an option is complicated and beyond the scope of this post.
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