The Options Market
I.
Introduction
The options market is a market where the right to buy and sell an asset (usually
corporate stock), at a fixed price anytime within a specified period of time, is traded.
The right to buy an asset is called a call option, while the right to sell an asset is called
a put option. In the stock options market, a call option contract gives its holder the
right to call away stock at a fixed price from a person called the writer anytime within
a specified period. Similarly, a put option contract gives its holder the right to sell to
or put to the writer 100 shares of stock.
Options are financial derivatives because their value depends on the value of the
underlying asset. Like any financial instrument, options have prices which are called
premiums. To buy a call or put option, one must pay the options premium. This
premium is paid to the writer or seller of the option. Writers are investors who create
and then sell their call or put options. Naturally, buyers can always sell their calls or
puts to other buyers. Therefore, the options market has two sides -- the buyers of calls
and puts and the sellers and writers of calls and puts.
All options have an exercise price which is also called their strike price. For
example, a call option gives its holder the right to buy 100 shares from the writer at
the strike price. If the call option is not used or exercised during this period, then it
expires and its holder (the buyer) loses the premium paid for the option. The same
will be true for put options. Therefore, each option has an expiration date. The
premium on this option will change over its lifetime.
Ideally, one would like to buy an option having a low premium and then offset
the option when its premium rises. For example, suppose that you buy a call option
on stock X and the price of stock X in the secondary market advances. The value of
this call will also advance. If you now wanted to take your profits, you could simply
instruct your broker to sell this call option. Note that you never actually bought 100
shares of stock X from the writer. You simply bought the call at a low premium, sold
it at a higher premium, and then took your profit.
Buyers of call and put options can lose money. If an investor buys put options
and the underlying stock price rises or doesn't change much, the option may be
worthless. The buyer will lose the premium he paid for the option. The writer, who
received the premium, profits in this case. The buyer also has to worry about when
exactly the stock will fall in price. If the stock falls after the put option has expired,
then once again he has lost his premium. Therefore, buyers of puts and calls must be
confident of both the direction and timing of changes in the stock's price. Three
things can happen to a stock price, and two of these are bad for the options buyer!
The writer (or seller) of options gets his profit from the premiums the option
buyer pays. The writer of a call option will make money if the stock price doesn't
change much or if it drops in price. He loses money if the stock price rises, and since
this rise can be substantial, the writer's losses can be very large. The writer of a put
option will similarly lose money if the underlying stock price declines. This loss can
similarly be quite large.
II. Options Quotations
For corporate stock options, the Wall Street Journal gives basic information
needed to keep abreast of the market. Each option is identified by its underlying
stock. For example, suppose that it is the month of March. Options are selling on
CITICORP which is a bank holding company which owns the US based CITIBANK.
The options being traded on CITICORP will be identified in the newspaper as
CITICP. Under this will be given the most recent closing price for CITICORP stock
on the NYSE. Next, the strike price on the option will be given, say $35. After this
will come the expiration month, which we can assume is July. The volumes and
premiums for both calls and puts are then listed. For example, the call's price might
be $5 5/8 = $5.625 per option, and its volume that day might be only 19 contracts. The
put might have a premium of $1 3/16 = $1.1875 per option and a volume of 222
contracts traded. The standard contract involves 100 options (each option is on 1
share of stock), so that the total number of options transacted would be the
(volume)(100). Thus, if an investor buys one call contract, he pays a total premium of
$562.50, while to get one put contract he pays $118.75. Options can have different
strike prices and different expiration dates. For example, there may be a CITICORP
July option with a strike price of $45, while there may also be CITICORP April
options with a strike price of $35.
III. Hedging With Options
Like futures, options can be used to reduce the individual risks of holding an
underlying asset. For example, suppose that you are holding 100 shares of IBM stock.
You feel that IBM stock is likely to decline in the next three months. But, even if it
does, you feel it is best to continue to hold your shares. Perhaps this is because you
bought IBM at a very low price and if you sell it you must pay considerable taxes on
your capital gains. You would like to defer these taxes to the future. To hedge this
price risk you could buy a put options contract (equal to 100 separate options). You
would pay the writer a premium for this put. If IBM stock rose in price, then you
would make money on your underlying shares, but you would also lose on the puts.
The gains and losses would cancel. Conversely, if IBM's stock price fell in the
secondary market, then the puts would increase in value, so you would be hedged
against this price decline. The worse case would be if IBM's stock did not change in
price. In this case, you would simply lose the premiums you paid for the puts.
Calls can also be used to hedge price risks. Suppose you did not own IBM stock,
but you felt that IBM stock was going lower. You decide to sell IBM short in the
stock market. You would borrow 100 shares from your broker and immediately sell
these on the NYSE. If IBM stock moved lower, then you could buy the stock back
later, return the stock to the broker (with interest), and still make a profit. But,
shorting IBM stock exposes you to the risk of unlimited losses. If IBM stock rose
instead of falling, then you stand to lose a great deal of money. You can hedge this
risk by purchasing a call option on IBM stock. If IBM's price rises, then you lose
money on your shorting of IBM stock, but this is then balanced by the rise in your
call's premium.
Often firms having future obligations denominated in foreign currencies will
hedge their exchange risks by using foreign currency options. For example, suppose a
German importer must pay 1 million USD after 3 months. He is afraid that the
deutschmark (DM) will depreciate relative to the USD. To hedge his exchange risk he
could buy DM put options. If the DM did depreciate, his put options would increase
in value and cancel his exchange losses. Note that the company can hedge its risks by
being long (buying) puts, but it cannot hedge itself by going short (selling or writing)
calls on the DM. Note also that if the exchange rate does not change by much, then
the company will suffer losses equal to the premiums it has paid for the put options.
Therefore, the company must be very confident that the DM will depreciate
substantially within 3 months in order for its strategy to be correct.
IV. Important Aspects of Options
There are a number of important concepts which are related to the options
market. Let's consider some of these now.
First, if the stock price is greater than the strike price, the option is said to be in
the money for a call option and out of the money for a put option. Calls will out of the
money and puts will be in the money when the stock price is less than the option's
strike price. When the stock price is equal to the strike price, then both the call and
the put are said to be at the money”.
Second, premiums on calls and puts that are quoted in the newspaper are equal to
the price paid on the last transaction. Since premiums are determined on a bid-asked
basis, it is not clear which of these (bid or asked) is given in the newspaper. If the last
transaction was for an investor to sell an option, then the quotation is a bid price. If
the last transaction was for an investor to buy an option, then the price quoted was an
asked price.
Third, not only can one buy and sell options on a company stock, but stock
index options can also be traded. The Chicago Board Options Exchange trades stock
index options on the S&P 100, S&P 500, and the NASDAQ 100. Both the NYSE and
the AMEX also trade stock index options. Around 40% of all options volume is now
due to stock index options trading.
Finally, the sale or writing of options requires a margin deposit to be established,
and this margin will depend on the nature of the option. For example, a call can be
written in two ways covered and uncovered. A covered call means that the writer of
the option already owns the underlying stock. An uncovered call (sometimes called a
naked call) is one where the writer does not own the underlying stock.
Discussion Questions:
#1. What is a call option?
#2. Suppose I want to buy IBM put options. What do I expect about IBM's stock
price?
#3. Explain each of the following terms:
(a) options writer
(e) premium
(b) expiration month
(f) covered call
(c) strike price
(g) offset
(d) bid and asked prices
(h) stock index option
#4. What information is given in options quotations?
#5. When would one use a put option to hedge?
#6. When would one use a call option to hedge?
#7. What is the difference between a futures contract and an options contract?
#8. What is the difference between selling stock short and being short in the options
market?