Introduction to Options

General Features of Options

Introduction

In this tutorial, we will discuss the basic features of options to help you gain insight on what the option is, how options market is organized and how these contracts are traded. Then we will discuss the settlement rules of option contracts and the moneyness of options.

Definition

An option is a type of financial derivative. Derivatives are financial contracts and its value is dependent on or derived from underlying assets. The underlying assets could be stocks, indices, commodities, currencies, exchange rates, or the interest rate. When you trade options contracts, it can help you generate profits by betting on the future value or just the moving direction of the underlying assets. So, their value is derived from that of the underlying asset. This is why options are called derivatives.

Puts and calls are two basic classes of options. Call options give the buyer the right to buy the underlying asset at a certain price while put options endow the buyer the rights to sell them. For strict definition, a call/put option is a standardized contract that gives the buyer the right to buy/sell an agreed quantity n of underlying asset S, at a predetermined price K at maturity T. The seller of a call/put option is obliged to sell/buy the underlying assets if the buyer exercises the option.

First, we give the building blocks of an option contract and will discuss them further.

Style American Option: the holder of an option has the right to exercise his option at any time before the expiration date European Option: an option which can only be exercised on its expiration date
Type Call option, Put option
Underlying AssetThe security on which the option is bound. The underlying could be stocks(stock option), stock indices(index option), exchange rate(Foreign exchange option) or even futures(Futures Options). Note: The options in the tutorial refer to the stock options.
Premium The price of the option. (Premiums are quoted on a per share basis). The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.
Strike PriceThe specified price at which the stock can be bought or sold when the option is exercised.
Expiration DateThe last day that an options contract is valid. All options expire after a certain period of time. The right to exercise the option will no longer exist once the stock option expires.
Participants Holder: People who buy the options(have long positions) Writer: People who sell the options(have short positions)

Options Contract

Stock options are traded in units. Each contract entitles the option buyer/owner 100 shares of the underlying stock upon expiration. Thus, if you buy five call option contracts, you are acquiring the right to purchase 500 shares at expiration. For any given asset at any given time, an option can be bought or sold with multiple expiration dates and strikes. Suppose there are three expiration dates and four strike prices for options on a particular stock, there are a total of 24 different contracts if we consider both put and call options. Currently, all equity options traded on U.S. options exchanges are American-style. But many index options are European-style.

Let us use the example of Apple. You can buy and sell Apple shares (NASDAQ: AAPL), and you can also buy and sell Apple options. But not all stocks have options associated with them. This means that there may be no options available to buy or sell written on a certain stock. You can view the websites of the exchanges to find out which stocks do have options.

In this case, the stock AAPL is known as the underlying asset. The share price of AAPL is the underlying price. And a series of options contracts written on Apple are derivatives. Option contracts have their own symbols. For example, AAPL170728C00143000 is one of the option contracts, it is a call option and the strike price is $143. The contract expires on July 28th. The premium for this contract is $10. If you spend $10 cost on buying one contract, then you get the right to buy 100 shares of AAPL for $143 per share at any time before the expiration date.

The Value of Options

The option's premium consists of two parts: the intrinsic value and the time value.

\[Intrinsic Value_{call} = max(Current Underlying Price-Strike Price,0)\] \[Intrinsic Value_{put} = max(Strike Price-Current Underlying Price,0)\]

From the equations above, only in the money options have intrinsic value. After we know the intrinsic value, the time value is the difference between the options premium and the intrinsic value.

\[Time Value= Premium-Intrinsic Value\]

For example, an AAPL call option contract which expires after 10 days has strike $143 and premium $10. now the market price of GOOG is $160. The intrinsic value of this contract is 160-143=$17, the time value is 17-10=$7. Although the intrinsic value of OTM and ATM options is zero, they have time values if they still have a certain amount of time until the option expires so for OTM and ATM options, their premiums equal their time values.

Options Moneyness

Option moneyness describes the relationship between an option's strike price and the underlying asset's price. It has important implications for options trading.

At the Money(ATM) The strike price is the same as the current price of the underlying asset
In the Money(ITM) Call Option: the strike price is below the current trading price of the underlying Put option: the strike price is above the spot price of the underlying
Out of the Money(OTM) Call Option: the strike price is above the current trading price of the underlying Put Option: the strike price is below the current trading price of the underlying

For example, if the price of Apple stock is at $140, then all calls with a strike price below $140 are in the money calls, all puts with a strike price above $140 are in the money puts. All calls with a strike price above $140 are out of the money calls, all puts with a strike price below $140 are out of the money puts.

But why are they in the money or out of the money? For a call option as an example, it is ITM because it already has an intrinsic value. If you buy the call option and own the right to buy AAPL at strike price $143 and the current market price is $150, then this call option is in the money 150-143=$7. If you need to exercise it, you can buy shares of AAPL at $143 and sell them immediately for $150 and secure $7 profit.

Likewise, for a call option, it is OTM because it doesn't have any intrinsic value. If you buy the call option and own the right to buy AAPL at strike price $143 and the current market price is $130, then this call option is out of the money 130-143=$13. If you need to exercise it, you can buy shares of AAPL at $143 and sell them immediately for $130 and then you will lose $13. In this case, you would not do that. But why this kind of OTM options still traded in the market and you need to pay for them? That because they still have time values and have time to expiration. There is probability or there is the expectation from the OTM option holders that the apple price will go up and above the strike price before the expiration.

Exercise and Assignment

When you are the buyer of an option you have three ways to deal with your options.

  • You can close out the position at any given point prior to expiration (For buyers, write options and for sellers, buy options);
  • Wait until the expiration date and out-of-the-money options will become worthless;
  • Exercise the options which are in-the-money, resulting in a trade of the underlying stock (The seller will be assigned the obligation to sell or buy the underlying stocks)

For all of those methods, closing out an option in the market is the most frequently used method. At the expiration, you need to deal with the option exercise if you long the options. If you short put or call options, you have to think about the assignment.

  • Exercise: Exercising option means that the option holder executes the right to buy or sell the underlying assets at the strike price.
  • Assignment: When an option is exercised by the option holder, the option writer will be assigned the obligation to deliver the terms of the options contract. This is called the option assignment.

To be concrete, if you write a call option and the option holder decides to exercise, then you must sell the obligated quantity of the underlying security at the strike price to the option holder. Suppose you hold the underlying shares while writing the call option (covered call), those shares would be transferred from you to your counterpart. If you do not hold those shares in your account (naked call), you would then short those shares and deliver them to your counterpart. In another case, if you short a put and the holder decides to exercise, then you must buy those shares. You would now long shares in your account and don't hold options.

Summary

An option is a standardized contract between two parties to buy or sell an asset for a certain price. Options are pretty different from equity trading. Here we concerned primarily with the stock options. This chapter we present some introductory material on options market like the basic features of options contracts and the options trading mechanism. In addition, we explain how options markets are organized, how the contracts are traded. Next chapter we will take a close look at how to use QuantConnect API to start your options trading algorithm.

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