ETF Options 101

April 11, 2018

What are options?

Options are securities whose price depends on an underlying asset such as a stock (because of that property, options are qualified as derivatives). In essence, an option is a contract between two parties, a buyer and a seller, that grants the buyer the right—but not the obligation—to buy or sell the underlying asset for a preset price (known as the “strike price”) on or before a preset date (known as the “expiry date”). The seller of the option has the obligation to fulfill the contract requirements if the buyer decides to execute (known as “exercising”) the option.

How is an option defined?

Several parameters describe an options contract. For “vanilla” options (simplest type of options), the most important parameters describing the contract are as follows:

 

Parameter

Description

Example

Underlying

The asset on which the option is built

AAPL (Apple stock)

Strike Price

The price at which the underlying can be bought or
sold (depending on the option type)

$180

Expiry Date

The date that marks the end of the option
contract. Once the expiry date is reached, the option is expired.

June 15, 2018

Type

Call option (the buyer has the right to buy the
underlying asset)
Put option (the buyer has the right to sell the
underlying asset)

Call

Style

American option: The option contract can be
executed any time up to expiry date.
European option: The option contract can only be
executed at the expiry date.

American

Contract Size

The number of units of the underlying asset that
the option gives right to. Contract size is also
referred to as the lot size.

100

Settlement Method

Physical: The underlying asset is delivered
Cash: The difference in price between the
underlying asset price and the strike price is
delivered

Physical

 

The option described above is an AAPL call option expiring on June 15, 2018. It gives the buyer of the option the right to buy 100 stocks (contract size) of AAPL stock any time before or on the expiry date (American option). If the buyer executes the options, he will pay $180 for each AAPL stock and receive the stock in his portfolio (physical settlement). The total amount the buyer would need to pay if he decides to execute the contract is $180 * 100 = $18,000.

What is option moneyness?

The moneyness of an option refers to the relative position of the underlying asset price with respect to the strike price. An option is at any time in one of three states:

  • ATM (at the money): The strike price of the option is the same as the price of underlying asset.
  • ITM (in the money): The strike price of the option is below (for a call) or above (for a put) the price of the underlying asset. If you exercise an ITM option, you will make money.
  • OTM (out of the money): The strike price of the option is above (for a call) or below (for a put) the price of the underlying asset. If you exercise an OTM option, you will lose money. You don’t under normal circumstances exercise an OTM option.

Are ETF options available?

Option contracts are available on a multitude of underlying assets. Examples of underlying assets are stocks, ETFs and commodities such as gold, silver, livestock or corn. One popular ETF option chain (series of options) is for the SPDR S&P 500 ETF Trust (SPY) underlying. SPY options are traded on several exchanges, including the Cboe options exchange. Option chains can be viewed on https://www.cboe.com/delayedquote/quote-table

Where are options traded?

Exchange-traded options are option contracts traded on exchanges such as Cboe, NASDAQ or EUREX. These contracts have standardized specifications set per exchange. The buyers and sellers of the contract do not interact with each other but with the exchange, which also acts as a clearinghouse. If one of the parties goes bankrupt, the exchange guarantees the enforcement of the contract.

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