What it means
An option has two main types. A call option gives the right to buy an asset, such as a share, at an agreed price called the strike price.
A put option gives the right to sell at the strike price, and in both cases the holder pays an upfront fee called the premium. What makes an option exchange-traded is that the contract is standardised.
The exchange sets the underlying asset, the size of the contract, the available strike prices and the expiry dates. For US equity options, one contract usually covers 100 shares, which is why premiums are quoted per share and then multiplied by 100.
A clearing house sits between every buyer and seller and guarantees performance. This reduces counterparty risk (the danger that the other party fails to honour the deal), which is a key difference from over-the-counter options negotiated privately between two firms.
It also allows positions to be closed easily before expiry by trading the opposite contract. Businesses use exchange-traded options to manage risk.
A company that holds shares can buy puts as insurance against a fall, and an importer can use currency options to cap the cost of a future payment. The most the buyer can lose is the premium, while the potential gain can be large, which makes the structure attractive for hedging.
Sellers of options, known as writers, take on more risk because they receive the premium but must perform if the buyer exercises. Writing a call on shares that you do not own can lead to very large losses, so exchanges and brokers set margin requirements (deposits that cover potential losses).
Anyone using options should understand time decay, because the value of an option falls as expiry approaches if the price does not move in the buyer's favour.
In practice
Real-world examples.
Example
A fund manager holds $5 million of technology shares and worries about a market fall before year end. She buys put options on a stock index that cost 1.5% of the portfolio value. If markets fall, the gain on the puts offsets part of the loss on the shares.
Example
A coffee roaster wants to protect against rising prices but has no storage room for beans. She buys call options on coffee futures at a fixed strike price. If prices jump, the options increase in value and help to pay for the higher cost of supplies.
Example
An individual investor believes that a retailer's shares will rise after its next earnings report. He buys short-dated call options for a few hundred dollars. The shares rise modestly, and the premium he paid is higher than the profit, so he loses money despite being right about the direction.
Formula
Calculation
Call option profit at expiry = (Share price at expiry - Strike price, but not less than zero) x Number of shares - Premium paid
Suppose an investor buys one call contract on 100 shares with a strike price of $50 and pays a premium of $3 per share, a total of $300. At expiry, the share price is $58.
Value at expiry = ($58 - $50) x 100 = $800.
Profit = $800 - $300 = $500. If the share price had ended at $50 or below, the option would expire worthless and the loss would be limited to the $300 premium.Case study
Seen in the real world.
Harborview Foods is a fictional company that holds a large stake in the shares of a supplier. The CFO wanted to protect the value of the stake for six months but did not want to sell because of tax and strategic reasons.
The treasury team bought exchange-traded put options on the supplier's shares, with a strike price 10% below the current price. The premium cost about 3% of the value of the holding, and the treasury recorded the cost as a hedging expense.
In this illustrative case, the supplier's shares fell by 25% after a profit warning. The put options rose in value and limited the company's loss to about the 10% gap plus the premium. The board agreed that the cost of the hedge had been worthwhile, although it recognised that in a year when the shares rose the premium would have been lost.
Watch out
Common mistakes.
- Assuming an option can only gain, when the full premium can be lost if the price does not move in the right direction before expiry.
- Ignoring time decay, which erodes the value of an option each day as expiry approaches.
- Treating writing options as free income, when the writer can face large losses and margin calls.
Questions
People also ask.
What is the difference between an exchange-traded option and an over-the-counter option?
The exchange-traded version is standardised and cleared centrally, while an over-the-counter option is a private contract that can be tailored but carries counterparty risk.
What does it mean to exercise an option?
It means using the right to buy or sell at the strike price. Many holders instead sell the option before expiry to capture its value.
Can a company use options for hedging?
Yes. Companies use them to cap costs, protect asset values and manage currency or commodity exposure, with the premium acting like an insurance charge.
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