Lesson 1 – Option Basics

Introduction

This may be your first course about options. Let me introduce what options are first. Options are a popular, versatile trading instrument. They allow you to create short-term profits movements in the markets. These movements can be up, down, and sideways directional movements. However, they offer longer-term investment positions as well. More importantly, they can unlock returns from your portfolio investments.

Keep in mind that this is similar to learning a new language; take your time, and repeat the work with the examples we provide and always remember to take notes. Starting off may be a little difficult when trying to get the hang of the words and context, but that is what this course will aid you in. This language of options simply needs a little breaking into, and you will be a fluent user in no time!

During the course of this progression, you will be learning:

• What options are

• Discussions on the reasons for using options

• An introduction to the key terms.

What really are ‘options’?

Historically, options have initially been used for the purpose of hedging, which is a system of risk management. In recent times, it is more of a trading tool used for leverage gaining. Ancient Greece shows one of the earliest uses by Thales, who was a philosopher and mathematician. Thales used this contract in securing lower olives prices prior to harvests. The next historical note was in Holland in the early 17^th century within the tulip trade. Unfortunately, as the industry collapsed, the traders did not honor the contracts agreed upon.

The UK trading of options shows proof of being in existence since the late 17^th century, whereas in the US (which is the largest global options trading market), the trade has been in existence for a similar time though the formalized Chicago Board Options Exchange was initiated in 1973. In Australia, the beginning was in 1975.

When looking at what this, an options contract truly refers to, it is a contract between two parties by which a right is given to buy or sell, this is known as an Exchange Traded Options. The Buyer in this contract is named as Taker, and the seller is the Writer. Keep note of these standard terms as they will be explained further within this course. The ETO’s (Exchange Trade Options) can include but are not limited to bonds, stocks, and commodities and even used for securing future contracts known as the system of Underlying. Here, there are a few terms that are essential;

• The cost established within a contract is known as premium.
• This has a date in the future named for the expiration of the contract called the expiry date.
• This combined help to specify the strikeprice, which is the price that is essential for the will exchange hands.

The components of an option contract are recognized within a stock exchange. This will allow a fairground for all the parties involved.

How does a call option work?

Imagine a situation where you want to buy BHP because you believe that the price of the stock would likely rise in the near future. The concern is that you do not have the money at hand to buy/ invest immediately. The available alternative would be to pay a minimal premium and purchase a Call option of BHP. This would automatically give you the right to buying shares at future dates.

This forms the basics of an options contract in simple terms. There is more that needs to be explained further and will be done in time.

Further interpretation can be gained by examining the Call option definition. Simply put, a Call option provides the Buyer (Taker) with the right to buy (without an obligation) the principal asset at an agreed price on or before a particular date.

If we explain this concept by elaborating what a Call Option is,

If the BHP example is further elaborated, provided that the purchase was made on Dec 2011 as 40.00 Call option on BHP, the right, without the obligation, of the purchase of BHP shares on or before its expiry on Dec 2011, by making a payment of $40.00 for the acquisition of the shares would be allowed. For the holding of this contract or even the right, the payment of a premium for a contract — at a rate of around $2.00 per share would be required.

However, on expiry, if the share price was at a rate of $70.00, the contract exercising would allow buying shares at the initial option strike price of $40 per share. This will be synonymous with gaining a profit of $30 after subtracting the cost of option purchase, which was $2. Thereafter the option of resale of shares at the $70 market value or holding for the future is with the holder of the shares.

Alternatively, if upon expiry the share price fell to $20, it would be a choice of if the contract would be exercised or not, therefore allows the buying of shares at $40 strike price. Unquestionably, it would be a worthless investment and cause a loss. Thus, in almost all of the examples where the share price is one that is below the strike price of a Call option on expiry, the options will expire worthlessly.

The Call options will be explained in detail further on,

Thereinafter, we look into the next, which is a Put Option.

Within a Put Option, the Buyer (Taker) is given the right without the obligation for the sale of underlying assets at a given price on or before a given date mentioned in the future.

The conception may be a new one for you. However, the basis is that you are given the ability to sell the shares at set prices at different named future dates. Here it is allowed for you to pay a premium rate for the purchasing of this right. However, notwithstanding how the share prices may change, you are given the opportunity to sell shares at a determined price. This is known as insurance for stocks. For example, suppose

 you are a shareholder of a company and if you are concerned about a price drop within a recent time

In a situation where you have the ownership of Telstra shares. You may fear that the stock price is probable to fall within the next six months and thus decide to buy a Dec 2010 $4 Put option. This provides you with the right to sell the TLS shares at $4 on or before their expiry date in Dec 2010. In order to have a hold of this contract, you might pay $0.40 per share.

But on expiry, if the share price of TLS fell to $3, you may exercise the Put option contract, and thereby sell your shares at the initial Strike price of $4. You have purchased the ‘Put protection,’ and as a result of a fall in shares, you have been able to lock in the sell price.

Provided that, upon expiry the share price of TLS had increased to around $5, you would not be obliged to exercise the Put option contract. You are able to sell your shares at the market for profit-making (with consideration to the original buy price), with the put option expiring will be worthless on the claim on insurance. However, the purchase is generally made all the same. If something had happened, the right to claim could be exercised, either through repairing or replacing at established values. A Put option, therefore, provides for you to hold a means of protection against the shares you own, yet it doesn’t require to be locked into the sale.

Hereinafter, these Call and Put options would be discussed in detail. Firstly, the discussion needs to be about the usage of the option for the process of investing and trading purposes. Here, the main notable reasons are as follows;

• Leverage

• Risk Limitation  

• Diversification

• Time to Decide

• Hedging

When looking in detail about the reasons, the first is Leverage. This is the system of using minor capital for gaining market exposure. This brings the ability to improve the gaining of returns to be earned from the investment. However, this is a risky venture as it may cause losses if not properly managed.

Thereafter, options are also known as the primary tool in risk limitation. It is known that the biggest risk an investor takes is the risk of a breakdown in the market. The possibility of allowing insurance against such failure is a possibility, as will be explained herewith.

Let’s look into the diversification of the reach into various markets. The reach opens into the various asset classes such as commodities, indexes, and even currency with the same ease of directly trading shares.

The most interesting ability within the option trade is the provision of Time to Decide. Simply put, when you buy an option, it allows you time to consider and make a decision before acting further. This is useful in decision making within volatile market conditions.

The hedging ability that is given within options allows for portfolios to be hedged against any adversities that may occur and thus providing protection against adverse movement or potential market failures. This is generally useful when unsure about selling portfolios in a market that may potentially fail.

Discussing key terms is a mandatory requirement since it will be applicable throughout your career as an options trader/investor.

Exchange standardizes the Exchange Traded Options. The alternative allows for Over the Counter (OTC)options offered by different component provision firms. Now since the more standardized Option Components within an Exchange Traded option have been identified, a detailed look into the individual components is next;

• Strike: This is commonly known as the exercise price. The price referred here allows for the option buyer the choice to buy (for calls) or sell (for puts) the provided underlying asset. Prices change according to the series chosen by the investor/trader, although generally, there are consistent boosts between the series.

• Expiry Date: as the term states, it is the date on which the option expires (in Australia, it is the last Thursday of the month)

• Underlying Asset: It includes but is not limited to stocks, Commodities, Bonds, and so forth. Generally, trade is based on stocks

• Contract Size: Continuing with the Australian example, one option contract parallels to an equivalent of 100 shares each.

• Exercise Style: The two main types of exercise styles are European and American. Within the European system, options are only allowed to be exercised based upon the expiry date. In the American style, however, exercising is allowed at any time up to and on the expiry of options. Generally, the American style is more popular for stock options, whilst index options are mostly European.

• Premium: This is usually quoted in the price per share and will, therefore, fluctuate up and down according to various reasons. This is the price that one pays in order to hold an option contract. Usually, the professional options traders/investors and other relevant market makers use formulas to calculate a “fair value” of the option premium being traded. This value, which would have been consequential to the underlying asset value, affects the options price decision. There are two components within this price known as the Extrinsic Value and Intrinsic Value, which will be discussed in detail within the Option Pricing lesson.

Within the discussion of terminology, the participants of trade options are a mandatory component as shown below;

Market Makers: These are the professional traders who generally cover two stocks. They are generally indulged in providing both buying and selling prices for chains of options. They are the people who contribute to the liquidity provision within markets by allowing quotations. An example would be the use of March, June, Sept, and the month of Dec for contracts with the strike prices named at particular intervals.

Various tactics would require persons to be a Writer or Taker accordingly and may even require one person to act as both in certain circumstances. This would require you to familiarize yourself with the terminology, then with the laymen terms such as Buyer or seller.

It would be a requirement to place one of the below-mentioned orders for buying and selling purposes:

• Buy to Open (BTO)

• Sell to Open (STO)

• Sell to Close (STC)

• Buy to Close (BTC) Orders

When clarifying further, if you BTO a Call/ Put option, this is known to be an entry position for the opening transaction. If leaving such a transaction, the opposite action would be necessitated, and the action would be an STC. On the other hand, if the need was to STO a Call/ Put option, the selling side would be ones with the capability of opening a position (through the sale of options). Due to this, closing trade requires the opposite, which is a BTC.

Explaining a few additional actions further;

A settlement on options is calculated as T+1. Elaborating with an illustration, if a purchase was made to open a Call option on a Tuesday, then the settlement would be required on Wednesday. However, when in shares, the settlement calculation is at T+3, thus allowing the settlement time to be Friday, provided that the shares were bought on Tuesday. An important point to note would be that the options market is generally opened from 10 am to 4 pm EDST, from Monday to Friday.

The prices of the strikes are also provided with alternative terminology and are referred to as At the Money (ATM), Out of the Money (OTM), and/or In the Money (ITM). The variation of the prices comes with the alterations of the underlying share price. The stock price is in relation to the strike price is extremely important. Therefore the identification of ATM, OTM & ITM strikes is of critical necessity.

Strike prices are referred to as either At the Money (ATM), Out of the Money (OTM), or In the Money (ITM). Option strike prices will vary between ATM, OTM, and ITM as the underlying share price moves up or down. When entering a position, where the stock price is in relation to the strike price is very important, so identifying the ATM, OTM & ITM strikes is critical.

The ITM & OTM Put options are very much different from ITM and OTM Call options; these would be later discussed in upcoming courses.

When an option is further distanced from expiration, the time value of the option price is enhanced. This system is known as Time Decay.  The time value diminishes as the expiry date closes. This would mean that at the point of expiry, the option would have no value attached to it.

The distinguishable fact is that with increased volatility, it calls for investor emotions to be disconcerted, whereas decreased volatility allows investor emotions to be calmed.

Open Interest: is a reference to the total of unsettled contracts that are open for trading purposes. The larger the opening denotes frequent activity leading to the liquidity of contracts.

Liquidity: the buying and/or selling allowing for conversion without causing movement of the price at a substantial scale, leading to assurance of minimum value loss within the process. A trader in an illiquid market may be required to pay added values or receive lower values in the buying and selling process of the options.

Conclusion

In this lesson, we discussed what options truly are. Further, we discussed the reasoning behind the use of options, and it’s terminology. Allow yourself to institute yourself on the groundwork laid within this chapter prior to moving onto the next one firmly.