What is an option exactly?

An option is a contract that grants the right but not the obligation to buy or sell an asset at a fixed price before a predetermined date. What this means is, you as the holder of the option contract is granted the choice of whether or not to execute the contract before the expiration date to buy or sell the underlying asset.

Anatomy of option

* Power of leverage

Using the stock market as an illustration, one option contract gives you the flexibility to either control, or, exercise the right to buy or sell 100 shares at a fixed price.

The option contract will consist of:

* Exercise price

The Exercise price is also called the “Strike” price. This is the “Fixed” price where you may exercise the option contract to buy or sell the underlying asset.

There are 4 options which the holder may choose. For illustration purposes, the stock market is used in the following examples:

Option 1:

When you purchased a option contract at a strike price of $100, u may exercise it to purchase the stock at $100 per share.

Option 2:

Wait for the underlying stock to rise in value and profit the difference between the share price less away the strike price from the sale of the stock option contract ( For example, the underlying stock has risen to $120, the option contract you bought at the beginning has a strike price of $115, as a result, the contract you bought has risen by $(120-115) = $5, you may sell the contract to make a profit of $(5×100 shares) = $500 per contract. This do not include necessary brokerage fees that you have to pay when making each trade.

Option 3:

Exercise it to purchase the underlying stock at the strike price which is cheaper since the stock has risen in value if you want to own the stock.

Option 4:

Choose not to exercise the option contract and allow the contract to expire worthless.

* Expiration date

This is the date where by the option contract can be exercised before it expire worthless. Option contracts written by sellers will consist of an expiration date where buyers of the option contract can choose to make a profit or loss by selling back the contract, or exercise it to own the underlying security before the expiration date.

Buyers ( Holders ) V.S Sellers ( Writers )

* Buyers ( Holders ) Are Entitled To Rights

Option contract buyers who are also known as holders, are entitled the right but not the obligation. What this means is, you as the buyer of the option contract, is entitled to buy or sell the underlying security but you are not obliged to do so if you choose not to. The overall risk of the buyer is limited to the amount of capital paid upfront for the purchase of the option contract, inclusive of the brokerage charges. Look at the following illustration for explanation:

A buyer bought 5 stock option contracts at a price of $5 per contract, the calculation will be ->

$ [(5×100 shares) x 5 contracts] + $15 ( Total Brokerage fees for purchasing 5 stock option contract positions ) = $ 2515

$ 2515 is at risk if the market goes against the trader or investor when they first bought the stock option contract.

* Sellers ( Writers ) Are Bounded By Obligations

Option contract sellers who are also known as writers, are obliged to purchase the sold contract back or fulfill the contract terms when the buyer of the stock option contract chooses either to sell the contract back or exercise it. What this means is, you as the seller of the stock option contract is either obliged to purchase the contract back if the buyer chooses to sell back his contract when he first bought it,  or fulfill the terms of the contract to purchase the underlying security ( Stocks/Shares ) and deliver to the buyer if the stock option contract is exercised. The overall risk of the seller is unlimited if the contract is sold naked, which means that you have not hedged your position. This is because of the fact you are obliged to purchase back the stock option contract even if the market turns against you, this includes the event which the underlying asset may collapsed overnight due to bankruptcy and fall to a value of $0. Look at the following illustration for explanation:

A seller sold 5 option contracts at a price of $5 per contract, the calculation will be ->

$ [(5×100 shares) x 5 contracts] – $15 ( Total brokerage fees for selling 5 option contract positions ) = $2485

$2485 is the premium received by the seller when the option contract was written and sold to any potential buyers in the market, and the amount of this premium is at its maximum if the option contracts expire worthless in the favor of the seller. However the risk is tremendous when the contracts are written naked ( No hedging of this position of 5 contracts to “cover” or protect the sale of the option contracts ), this is because u are obliged to purchase back the option contract if the buyer decides to sell them or to purchase the underlying security and deliver to the buyer if he/she decides to exercise the contract. Imagine a scenario where you are selling the option contract and expected the market to rise, instead the market crashed and the underlying security the option contract was written for loses almost 80% of its market value or worst collapses due to bankruptcy, you will be liable and obliged to fulfill the terms in the contract or purchase back the worthless option contract.

To find out more, stay tune for Option Basics – Part 2.

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