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This chapter is from the book

The Definition of an Option

An option is defined as the “right, not the obligation, to buy (or sell) an asset at a fixed price before a predetermined date.”

Let’s have a look at that definition and see if we can pick out the component parts:

  • the right, not the obligation
  • to buy or sell an asset
  • at a fixed price
  • before a predetermined date

These component parts have important consequences on the valuation of an option. Remember that the option itself has a value, which we look at after we finish with the definitions.

Before we go ahead and look at the ways in which options are valued, let’s consider the words, “right, not the obligation.”

The Right, Not the Obligation

Buying Gives You the Right

  • Buying an option (call or put) conveys the right, not the obligation, to buy (call) or sell (put) an underlying instrument (for example, a share).
  • When you buy an option, you are NOT obligated to buy or sell the underlying instrument—you simply have the right to do so at the fixed (exercise or strike) price.
  • Your risk when you buy an option is simply the price you paid for it.

Selling (Naked) Imposes the Obligation

  • Selling an option (call or put) obliges you to buy from (with sold puts) or deliver (with sold calls) to the option buyer if he or she exercises the option.
  • Selling options naked (for example, when you have not bought a position in the underlying instrument or an option to hedge against it) gives you an unlimited risk profile.

Combined with the fact that you are obliged to do something, this is generally NOT a preferable position in which to put yourself. Only advanced traders should contemplate selling naked options, and even then they should have a protective strategy in mind to cover the downside (see Figure 1.1).

Now let’s consider the words, “to buy or sell an asset.”

Types of Options—Calls and Puts

A call is an option to BUY.

A put is an option to SELL.

Therefore,

  • A call option is the right, not the obligation, to BUY an asset at a fixed price before a predetermined date.
  • A put option is the right, not the obligation, to SELL an asset at a fixed price before a predetermined date.

Types of Calls and Puts

Options can be either American-style or European-style:

  • American-style options allow the option buyer to exercise the option at any time before the expiration date.
  • European-style options do not allow the option buyer to exercise the option before the expiration date.

Most traded options are American-style, and all U.S. equity options are American-style.

American-style options are slightly more valuable than European-style options because of their added flexibility. It is logical that being able to exercise before expiration must be more valuable than not being able to.

As a rule, stock options are generally American-style. Futures options are generally European-style.

Diagram 1.1. • American- and European-style options.

Now we need to look at the words, “at a fixed price.”

Exercise (or Strike) Price

The exercise (strike) price is the fixed price at which the option can be exercised.

So if you buy a call option that has a strike price of 50, then you have bought yourself the option to buy the asset at a price of $50.

However, in the real world, you want to exercise your right to buy that asset only at $50 if the underlying asset is actually worth MORE than $50 in the market. Otherwise, there would be no point. It would mean buying the asset for $50 when it’s only actually worth, say, $40 in the marketplace. No one would do that because they could buy it for $40 in the market.

This leads us to the words, “before a predetermined date.”

Expiration Date

This is the date before which the option can be exercised.

At expiration, the call option’s own value is worth only the price of the asset less the strike price, and at expiration, the put option’s own value is only worth the strike price less the price of the asset. For U.S. equity monthly options, the expiration dates fall on the Saturday after the third Friday of every month. Weekly options have gained in popularity, but they are still not quite as actively traded as the traditional monthly options.

This leads us onto the topics of intrinsic value and time value.

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