Option (finance)

In finance, an option is a contract giving the buyer the right to buy or sell an asset at a predetermined price on or before a specified date. The buyer, also known as the owner or holder of the option, is not obligated to buy or sell. The price is known as the strike price, and the date specified in the contract is the expiration date. Types of options are call options, which allow the holder to buy an asset, and put options, which allow the holder to sell the asset. Option assets are usually equities, or the cash value a shareholder would receive if the company’s assets were liquidated and all debts were paid.

Early options markets frequently involved illegal activities. For this reason, and because the potential for illegal actions remains, in modern times options are closely scrutinized by financial oversight agencies, including the Securities and Exchange Commission (SEC).

Background

Options in modern terms date back to 1973, but have their roots decades earlier. They apparently were created in bucket shops, which were run by stock price speculators who did not own securities but bet on their future prices. Bucket shops are comparable to modern boiler rooms, which are illegal operations in which brokers create artificial demand for stock companies, or in some cases fabricate companies and keep money clients provided to buy company shares. The most famous bucket shop operator was Jesse Livermore, who began his career in finance in Boston, Massachusetts, as a stock option bookie. In that role, he took the opposite side when an individual speculated a stock price might increase or decrease.

Options are most often traded on the Chicago Board Options Exchange (CBOE) in modern times. The CBOE was founded in 1973. The exchange converted to a publicly traded corporation in 2010, taking the new name Cboe Global Markets, Inc. (Cboe). Traders often pronounce it “see-bo.” Cboe is the holding company, while the exchange is its primary asset. Cboe trading includes options, futures, and equities.

Overview

Options are derivative instruments. This means the price of an option comes from the price of the security, which might be bonds, currencies, stocks, or any number of valued items. The contract is between the options writer—the party that creates and sells the contract—and the options buyer. If the buyer does not exercise the option, the writer keeps the premium, which is the price the buyer paid for the option in the first place. Investors use options to hedge their risk, meaning to protect themselves from some development that was not anticipated, or to speculate.

The two types of options are call options and put options. The call option buyer has the right to buy the asset for a specified price. The put option buyer has the right to sell the asset for a specified price.

A number of varieties of options have been developed. Over-the-counter options are traded between private parties, most often an investor and an investment bank, and are not listed on an exchange. A vanilla option has no special conditions. It simply gives the buyer the right to buy or sell a security at a set price during a time frame. The American-style exercise is one type of plain vanilla option. It is an option contract that the holder may use any time between the purchase and expiration dates. The European-style exercise, on the other hand, is a plain vanilla option that can be exercised only on the expiration date. Exotic options are the opposite of plain vanilla options. These are any contracts that include complicated conditions, structures, or terms, or calculate the payoff using a complex formula.

Options have a reputation for being risky. This may be due in part to the potential for illegal activity or simply failure to understand how they work. While options do carry some risk, they offer several distinct advantages as well. They are less risky than equities, for example. Options do not require as much financial commitment as equities. They are also not greatly affected by gap openings, or opening stock prices after a period of no trading. Options are safer than stocks because they are a fairly reliable hedge. Investors often purchase stop-loss orders, which are meant to protect the investor from a steep loss. The stop order stops losses below a price determined by the investor, because it is executed when the stock hits or falls below the limit. Risks of stop orders include gap opens, for example, when news about a company breaks overnight or during a weekend, and the stock opens well below the stop order limit price. This triggers the sale when the market opens, long after it would have benefited the investor. A put option, however, is not affected by the hours the market operates. It can be executed at any time, any day. This form of hedging can prevent steep losses.

Another advantage of options is cost efficiency. Investors have a great deal of power with options. The investor who purchases shares outright must pay out for them immediately. The purchase of several calls representing many shares is significantly less expensive, which leaves the investor with more money to use elsewhere. To do so successfully requires the correct call to purchase, based on a number of factors the investor must weigh carefully.

This cost efficiency leads to another advantage of options. If the investor spends less money to acquire shares, and turns a profit, the return is a higher percentage.

The flexibility of options is another advantage. They can be used to offer greater investment choices. Options can be used to recreate other positions, called synthetics. Synthetic positions give investors several ways to achieve the same investment goals. For example, an investor may borrow stocks that the investor expects to fall in price and sell them to investors, with the expectation that the investor will buy them back at a lower price before the shares must be returned. This is known as short selling. An investor who wants to short a stock must pay a broker a margin requirement, the maximum percentage of the investment that the brokerage firm may loan. This may be quite expensive, and increases the risk of loss while short selling. In addition, many brokers do not allow for shorting of stocks. They do permit investors to purchase puts to play the downside, or when value falls.

Bibliography

Abraham, Stephan A. “The History of Options Contracts.” Investopedia, 25 June 2019, www.investopedia.com/articles/optioninvestor/10/history-options-futures.asp. Accessed 8 Apr. 2020.

Chen, James. “What Is an Option?” Investopedia, 19 Feb. 2020, www.investopedia.com/terms/o/option.asp. Accessed 8 Apr. 2020.

Ianieri, Ron. “The 4 Advantages of Options.” Investopedia, 25 June 2019, www.investopedia.com/articles/optioninvestor/06/options4advantages.asp. Accessed 8 Apr. 2020.

Investopedia. “An Beginner’s Guide to Hedging.” Investopedia, 13 Oct. 2019, www.investopedia.com/trading/hedging-beginners-guide/. Accessed 8 Apr. 2020.

Motley Fool Staff. “What Is Hedging?” The Motley Fool, 15 July 2016, www.fool.com/knowledge-center/what-is-hedging.aspx. Accessed 8 Apr. 2020.

“Option.” Investing Answers, 18 Sept. 2019, investinganswers.com/dictionary/o/option. Accessed 8 Apr. 2020.

“Options Dictionary.” Cboe, www.cboe.com/education/getting-started/options-dictionary. Accessed 8 Apr. 2020.

Scott, Gordon. “Chicago Board Options Exchange (CBOE).” Investopedia, 2 May 2019, www.investopedia.com/terms/c/cboe.asp. Accessed 8 Apr. 2020.