Author: martinchandra | Total views: 6 Comments: 0
Word Count: 1098 Date: Fri, 15 Dec 2006 9:21 AM

The Anatomy of an Option

Any time you read anything about options, it is incumbent upon the author to provide a brief introduction. This article is no exception.

Let's suppose you are house shopping, but are waiting to hear whether or not the job you are hoping for is actually going to be offered. You find the perfect house, but you cannot afford it unless and until your dream job becomes your real job.

What is sometimes done in real estate is that you buy an option on the house. You pay the seller of the house, say, $500 to hold the house and sell it only to you for $100,000 at your option any time within the next thirty days. (The three underlined numbers are the terms of the agreement and are negotiable.)

If you do not get the job or find something better, you will not buy the house, but you also will not get your $500 back. You paid $500 for the right to buy the house at the agreed upon price any time before your option expires. The seller accepted your $500 and has the obligation to sell you the house at the agreed upon price any time before expiration, if you choose to exercise your option. You paid for the option, so you hold all the cards (except the $500). This is a legal contract.

In the stock and commodities markets, the type of option we just described would be known as a call. A call typically represents 100 shares of a stock. In the commodities markets, a single option contract represents a single futures contract. (For simplicity, from this point forward, I will talk about options on stock. Just remember that the same discussion applies to options on futures.)

Owning a call gives the owner the right to buy 100 shares (usually) of the underlying stock at the agreed upon strike price at or before the expiration date. (I say "usually" 100 shares because, due to splits or acquisitions, there are times when an options contract may represent something other than 100 shares.) Selling a call gives the seller the obligation to sell, if asked, 100 shares of the underlying stock at the agreed upon strike price any time up until the expiration date.

The other kind of option is called a put, and it is exactly the same as a call with one simple difference. A put gives the owner the right to sell 100 shares (again, usually) of the underlying stock at the agreed upon strike price at or before the expiration date. You can think of a put as insurance. No matter how badly the stock price crashes, having a put means that you can sell your stock for the strike price. On the flip side, selling that put means you may be obliged to buy stock at far more than its current market price. An important distinction to always keep in mind: Buying an option gives you rights.

Selling an option gives you obligations. Buying an option cannot cost you more than what you pay for the option. Selling an option can cost you far more than what you receive for selling the option.

Let's examine the terminology of calls and puts. The underlying is the actual instrument such as a stock or commodity that is being represented by the options contract. In the real estate example, the house would be the underlying. Options are said to be derivatives because their value is directly tied to or derived from that of the underlying. An option has no meaning without an actual asset underlying it. It is the right to buy or sell that underlying asset that gives the option a reason for being and some value.

The strike price is the agreed upon price for which the underlying can be bought or sold under the terms of the option contract. In the real estate example, the strike price was $100,000. The expiration date, obviously, is the date when the option expires. The day after expiration, an option is worthless. This is the single most important fact about options that you must remember. This is why your friends think you are crazy for your interest in options. Unlike a stock, which you can hold forever, an option has a clearly defined shelf life.

One term remains, and that is the premium. The premium is what you pay for the option, when you are the buyer. Or what you receive for an option, when you are the seller. In our real estate example, the premium was $500. That's what it cost you to hold the right to buy the house any time in that thirty-day period. The last day of the thirty-day period would, again, be the expiration date.

Let's look at some scenarios and discover how market forces alter the value of an option. Let's suppose you hold the option to buy the house above, and the next day, a toxic dump is discovered in the backyard of the house. Is the house still worth $100,000? No way.

What's your option worth now? Very little. Would anyone be interested in buying from you your right to buy that house for $100,000? Unlikely. The owner of the house, however, gets to keep your $500. Yes, he's stuck with a house he can't live in or sell, but the premium is his to keep. Small consolation for him, and a small loss for you, but which position would you rather be in?

Let's look at another scenario, one that will make you feel a little better for the poor homeowner. Instead of a toxic jump, they discover a diamond mine in his rose garden. Aren't you happy for him now? Well, don't be. He would share your excitement. You can now buy his house, INCLUDING the diamond mine, for the previously agreed to $100,000. Again, though, he gets to keep the $500 option premium. At least this time he gets to sell his house for the price he had intended. All he has "lost" is the unexpected profits from the diamond mine.

Are you starting to see how tricky it can be an option seller? As the option buyer, you spent exactly $500. Your loss is limited to that $500. No matter what. The seller of an option, on the other hand, has unlimited risk.

Was the real estate option in our example a call or a put? You bought the right to buy the house for $100,000, so, as we mentioned earlier, that's a call.