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 |
$180 |
Expiry Date |
The date that marks the end of the option |
June 15, 2018 |
Type |
Call option (the buyer has the right to buy the |
Call |
Style |
American option: The option contract can be |
American |
Contract Size |
The number of units of the underlying asset that |
100 |
Settlement Method |
Physical: The underlying asset 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.
How can options help an investor achieve a certain investment outcome?
Options offer several advantages compared to stocks for executing investment strategies.
Lower capital requirements
If you would like to get upside exposure to AAPL, you could buy 100 stocks of AAPL for $172, thus using $17,200. With options, you can get the same upside exposure by buying one call option for $50.
Improved risk management
In the example above, by owning the stock, you are exposed to both upside and downside of the AAPL stock. If the stock trades at $150, you would lose $22 * 100 = $2,200 on your AAPL position. By buying the call option, you are only exposed to the upside. So if the stock trades below $172, your loss is limited to your $50 investment.
Leveraged trading
Options allow for leveraging your trading considerably. Let’s consider that you have $17,200 to invest. You can use that money to buy stocks or options. The table below describes the potential profit and loss in each case.
Investment | Unit Price | Total Cost | Contract Size | Exposure |
(1) Buy 100 shares of AAPL stock | $172 per share | $17,200 | 1 | 100 shares |
(2) Buy 344 AAPL call options with a $172 strike price | $50 per option | $17,200 | 100 | 34,400 shares |
Let’s now look at our expected profit or loss if the price of the AAPL stock moves:
Investment | AAPL increases to $180 | AAPL increases to $172.50 | AAPL decreases to $170 |
(1) | $800 | $50 | ($200) |
(2) | $258,000 | $0 | ($17,200) |
Note the large difference in profit and loss potential with options. Because your exposure is 344 larger using options, your profit is much higher, but so is your loss. In the case of AAPL stock decreasing to $170, you would lose your entire investment had you invested in options. You can mitigate that effect by combining options, as we describe in the next section.
Complex strategies
Combining options, you can create an investment outcome scenario that provides you growth but also protection. Doing so is not possible by only investing in stocks or ETFs. The payoff of a stock position looks as follows:
One example of an option strategy is a collar strategy. If you are holding a long stock position that has increased in value, this strategy allows you to protect your gains while having some additional upside. The collar limits losses if the underlying asset drops below your protection price (A), but also limits your upside if the price of the underlying asset increases higher above your capped price (B). The payoff of a collar strategy looks as follows:
Another example of an option strategy is a covered-call strategy. In that case, you agree to receive an income to limit your upside at the cap price (A), but are still exposed to the downside if the price of the underlying asset drops. This strategy is useful if you want to generate income on a stock position you are currently holding. The payoff for a covered-call strategy looks as follows:
What is the Cboe Vest Technologies widget?
Options strategies are great but can be difficult to build. Using the Cboe Vest Technologies widget available on ETF.com, you can create the two options strategies described above. The tool will walk you through the steps to build your strategy and visualize in an easy way your upside and downside potential. Below we analyze collar and covered-call strategies. To learn the basics of how to manipulate the widgets, please check the Strategy Builder User Guide.
Collar Strategy
We created a collar strategy on SPY. In this example, SPY is trading at $271.44.
Parameters
The strategy has the following properties:
Expiry date | March 15, 2019 |
Upside cap | $320 (17.89% above current price) |
Downside limit | $230 (15.27% below current price) |
Costs
The total cost of this strategy is $27,685, which is equivalent to 100 contracts multiplied by the strategy cost for one unit of stock ($276.85). Buying the strategy, you are paying 1.99% premium relative to the price of SPY.
Holdings
To implement this strategy, you would be holding the following securities:
Payoff
The payoff of the strategy depends on the price of the underlying asset. This information can be visualized in the “How It Works” section of the widget by moving down the price at maturity slider.
- (1) If the price of the underlying is above $320, the payoff of the strategy is capped at 15.90% (which is 17.89% - 1.99% premium).
- (2) If the underlying trades between $230 and $320, the payoff of the strategy is similar to the payoff of the underlying less the 1.99% premium. This translates to a profit and loss between -17.26% and 15.90%, respectively.
- (3) If the price of the underlying is below $230, the payoff of the strategy is limited to 17.26% (which is $15.27% - 1.99% premium).
(1) Case underlying price is above $320
(3) Case underlying price is below $230
Covered-Call Strategy
We created a covered-call strategy on the PowerShares QQQ Trust Series 1 ETF (QQQ). In this example, QQQ is trading at $168.17.
Parameters
The strategy has the following properties:
Expiry date | Jan. 18, 2019 |
Upside cap | $200 (18.93% above current price) |
Costs
The total cost of this strategy is $16,670, which is equivalent to 100 contracts multiplied by the strategy cost for one unit of stock ($166.70). Buying the strategy, you are receiving 0.87% upfront income relative to the price of QQQ.
Holdings
To implement this strategy, you would be holding the following securities:
Payoff
The payoff of the strategy depends on the price of the underlying asset. This information can be visualized in the “How It Works” section of the widget by moving down the price at maturity slider.
- (1) If the price of the underlying is above $200, the payoff of the strategy is capped at 19.80% (which is 18.93% + 0.87% upfront income).
- (2) If the price of the underlying is below $200, the payoff of the strategy is relative to the payoff of the underlying + 0.87% upfront income.
(1) Case underlying price is above $200
(2) Case underlying price is below $200