CONTRACT SPECIFICATIONS
Options contracts have an almost unlimited range of specifications which are listed below:
| STRIKE PRICE | The Strike Price (or Exercise Price) is the price at which the underlying asset may be bought by the buyer of a call, or sold by the buyer of a put. |
| EXPIRATION DATE | This is the date by which the option must be exercised before ceasing to exist. |
| OPTION STYLE | Options contracts also differ depending on when and how they may be exercised: American Style: options that may be exercised anytime until expiry. European Style: options that may be exercised only in a defined period at expiry. Bermuda Style: options that may be exercised only a predetermined date, usually every month. |
| OPTION PRICING | Unlike futures contracts whose prices change depending on the price of the underlying asset, options prices or premiums are comprised of two components: INTRINSIC VALUE – This is the value of the premium derived from the relationship between the strike price and the current price of the underlying market. This relationship can be described in one of three ways: In-The-Money (ITM): calls with a strike price below the current market price, or puts with a strike price above the current market price. At-The-Money (ATM): calls and puts with a strike price equal to the current market price. Out-The-Money (OTM): calls with a strike price above the current market price, or puts with a strike price below the current market price. For example, a put with a strike price of $100.00 when the underlying market was trading at a price of $95.00 would be described as ATM, and have an intrinsic value of $5.00 since the buyer of the call could exercise the right to sell at $100.00 and immediately buy back at market at a price of $95.00 to secure a $5.00 profit per contract. Alternatively, a call with a strike price of $100.00 when the underlying market was trading at a price of $95.00 would be described as OTM, and have an intrinsic value of $0.00 since the buyer of the call would have no incentive to exercise the right to buy at $100.00 when the underlying market was trading $95.00. EXTRINSIC VALUE – This is the value of the option derived from its “optionality”, or it’s potential to become potential to become profitable sometime in the future before expiry. In contrast to an option’s intrinsic value however (which is simply derived from where the market is trading at the time), an options extrinsic value is derived from the following factors: Volatility: perhaps the most important determinant of premium value, volatility describes the degree of fluctuation in the price of the underlying asset. This will clearly be related to the likelihood of the option reaching its strike price and therefore becoming profitable – which is why higher volatility means higher options prices. In turn, options usually refer to two types of volatility – historical volatility (market volatility from the past) and intrinsic volatility (market volatility implied by current options prices). Time: options prices typically fall as time progresses, all other factors being equal. This is because the extent of market fluctuation falls as an options contract gets closer and closer to expiry. Interest Rates: the cost of money represented by the rate of interest is another important determinant of options prices, seeing as the return on investment in an option must be greater than the monetary cost of buying it. Dividends: although neither options buyers or sellers receive stock dividends, these payments reflect the difference between the cash flow received from the underlying asset, and those received from the option. Therefore, dividend payments by companies have clear implications for options prices. |
| OPTIONS GREEKS | In contrast to futures contracts whose risk is determined solely by market direction, options have a range of risk parameters which needs to be assessed and managed on a real-time basis. These risk variables are known as the Greeks, the most important of which are the following: GAMMA – The gamma of an option is the second derivative of the option price with respect to the price of the underlying asset, and as such measures how quickly the option premium changes because of changes in the value of the underlying asset on which the option is based. For example, an option with a gamma of 0.10 would see its delta change by 10% for a 1% change in the price of the underlying asset. THETA – The theta of an option is the first derivative of the option price with respect to time, and as such measures how quickly the option premium changes because of the option getting one-day closer to expiration. VEGA – The vega of an option is the first derivative of the option price with respect to volatility, and as such measures how quickly the option premium changes because of market volatility changing by 1%. RHO – The rho of an option is the first derivative of the option price with respect to interest rates, and as such measures how quickly the option premium changes because of borrowing costs changing by 1%. |
| OPTIONS STRATEGIES | Options are highly popular trading instruments since they can be used to express a wide range of different market views. However, even the most complex and sophisticated options trading strategies (with colourful names as iron condors, 1×2 call spreads, straddles and strangles!) are comprised of one or more of four positions: buying a call, buying a put, selling a call, or selling a put. These four types of options trade are explained below. |
| BUYING A CALL | Purchasing a call involves paying a premium for the option to buy a particular asset at a certain price, and therefore represents a bullish market opinion. However, the downside potential is limited only to the premium paid – while the upside potential is practically unlimited. |
| BUYING A PUT | Purchasing a put involves paying a premium for the option to sell a particular asset at a certain price, and therefore represents a bearish market opinion. Just like buying a call however, the downside potential is limited only to the premium paid – while the upside potential is practically unlimited. |
| SELLING A CALL | Purchasing a call involves receiving a premium for selling the option to buy a particular asset at a certain price, and therefore represents a bearish market opinion. However, in sharp contrast to buying an option, the upside potential for selling (or writing) an option is limited only to the premium paid – while the downside potential is practically unlimited. |
| SELLING A PUT | Selling a put involves receiving a premium for selling the option to sell a particular asset at a certain price, and therefore represents a bullish market opinion. But just like selling a call, the upside potential is similarly limited only to the premium paid – while the downside potential is practically unlimited. |