Finally, options! This was my bread and butter. As part of my firm, I was an options market maker, that is, I provided liquidity (competitive bids and offers) in the options market. This role was partially possible given the extensive understanding of options and their risks hammered into us via the strict training we received.
So, what are options?
They're a lot like futures in that it is a promise (or a contract) made for a future delivery date. Unlike a future, in an option, you have the option (or choice) to exercise it or not. The fact that its a contract also means that you can sell one without actually owning one (much like a future contract). Keeping these in mind, let's look at the formal definition.
An option is the right (but not the obligation) to buy or sell the underlying asset at a specified price on or before a certain date. A call option gives the holder the right to buy the underlying asset; a put option gives the holder the right to sell the underlying asset.
Let's look at an example to drive this definition home. Then we'll look at and define the different parts of an option.
Bob works for Kellogg Cereal where it is his job to purchase the necessary corn to make cereal. To reduce his risk, he purchases a call option for $3,000 that gives him the right but not the obligation to purchase 10,000 bushels of corn for $4.00 a bushel on or before November 1st, 2010. On November 1st, 2010, if corn prices are lower than $4.00, Bob can go to the market and just purchase it for a cheaper price and allow the option to expire. If, however, corn is more expensive than $4.00, Bob can exercise his option and purchase the corn for $4.00 (cheaper than it is to buy it in the market).
Alright, let me define the different parts:
- Bob is the buyer. He holds the call option contract in his hand. He is the one who ultimately gets to decide if he wants to exercise the option or not.
- In this example, we do know who the seller is. However, something important to note is that the seller has absolutely no say in exercising the option or letting it expire. In a way, the seller is at the mercy of the buyer.
- It is a call option since the option gives Bob the right to purchase the underlying asset (bushels of corn) if he exercises the option
- The underlying asset is the bushels of corn, since that is what he would be allowed to buy if he exercises his option contract.
- The expiration date is November 1st, 2010. Bob can exercise his option on or before this date but afterward the options is worthless
- The strike price is $4.00. This is the price that Bob agrees to pay if he exercises the option
- The price of the option is $3,000. This is the amount of money Bob paid to receive the right.
- Finally, note that it is his right and not obligation to exercise the option as explained above. Notice that if Bob chooses abandon his option (i.e. let his option expire), Bob will have lost $3,000.
Still a bit confused? I'm going to give you a few examples to hammer it in. In each example, I will point out all the different parts of the option (buyer, seller, expiration date, etc.).
- You (the buyer) purchased from me (the seller) for a price of $6.00 (the price of the option) the option to buy (call option) from me a cup of coffee (the underlying asset) for the price of $5 (strike price) on or before Feb 28th, 2014 (expiration date).
- Andy the farmer (the buyer) paid Kellogg $250 (price of the option) to gain the option to sell (put option) to Kellogg Cereal (the seller) 5,000 bushels of corn (the underlying asset) at the price of $4.25 a bushel (strike price) on or before August 31st, 2015 (expiration date).
- Sonic (the seller) sells a call option to Knuckles that gives Knuckles the right to buy 100 golden rings (underlying asset) from Sonic for a price of $1,000 (strike price) on or before June 23rd, 1991 (expiration date). For the sale, Sonic received $67 (price of the option)
- Mario (the seller) sells a put option at $45 (price of option) to Luigi the farmer (the buyer) that gives Luigi the right to sell 500 mushrooms (underlying asset) to Mario at a price of $24.50 (strike price) on or before October 18th, 1985 (expiration date).
It can be a bit confusing as there are a lot of moving parts. Here's a word of advice: do not get the actual price of the option mixed with the strike price. The actual price is the value of the option contract, while the strike price is a part of the options contract that specifies at what price I can later buy/sell the underlying asset.
I hope this post made some sense. You probably won't understand completely until we see a few more examples. In the next post, we'll look into some simple PnL (profit and loss) graphs to show the potential winnings and losses of an options contract.