Understanding Equity Options

Welcome to the wonderful world of equity options. You may have heard that option trading is high risk, and indeed it is, for much the same reasons that spread betting is high risk. The instruments themselves are derivatives from the cash markets, and are highly geared, but options themselves were originally introduced to the US markets in the mid 1970’s as a tool for hedging risk. In other words they were a form of insurance. You paid a premium, a bit like car insurance, which covered you in the case of an accident. In the financial markets you bought some protection in case the market went in the opposite direction. In this article we look at equity options, which are those derived from the cash market share or stock.

In the early years, the options market was very small, with only a handful available on the larger blue chip stocks in the Dow 30 and other major indices. Today, the American market is enormous, with over 12,000 equity options available to trade. In the UK it is just under 100 (the blue chip shares mainly) which can be rather limiting, but if your trading is mainly in UK shares it is not a bad place to start.

OK, let me start with some definitions, and I will try to keep this as simple as possible (not because you will not understand) but because the terminology can be very confusing for newcomers. It took me 6-9 months to get comfortable with this so do not expect to pick it up straight away. Firstly there are two type of options as follows :

A Call Option - A contract representing the right for a specified time to BUY a specified security at a specified price

A Put Option - A contract representing the right for a specified time to SELL a specified security at a specified price

An option is a contract which gives the buyer the right, but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date. Right, let me try and explain. Suppose you are buying a classic second-hand car. You visit the owner, love the car, and agree a price, but explain that you will not have the cash for 4 weeks. The owner agrees to hold the car and the price for you for only 4 weeks, but on condition that you pay a small non - refundable premium for his trouble (this is in addition to the full price of the car)

This is what an option contract is - the car owner has effectively written an options contract to give you, the contract holder, the right to buy the car within the four week period, at the agreed price. Now, as the option buyer ( or holder ) you have an option to buy, but you do not have to if you change your mind. Which is why in the above definition it says ' the right but not the obligation' - if you change your mind you just walk away. All you have lost is your premium which the buyer keeps (even if you do decide to go ahead). The car owner, who has written the contract, has a contractual obligation to deliver the car at the agreed price, and he or she must deliver.

In summary, as an options buyer, you have choices - you can exercise the contract or walk away. As an options seller, you do not have any choices - if the contract is exercised you must deliver the asset. If we take the example a stage further (I know its not ideal but I hope it gives a feel for what these things are all about). Let us assume that whilst you are waiting for the bank to supply the cash, so that you can go ahead and buy the car, the original factory where the cars were made is destroyed by fire. Suddenly these cars increase in value sharply. You, however, have a contract in writing at an agreed price, provided you buy within the next four weeks. Now, you as the buyer or holder of the contract have two choices. Firstly, you exercise your contract by paying the seller the agreed price, and immediately put the car on the market and sell at a profit, or alternatively you sell your contract on to someone else, as it now has a higher 'premium' value due to the increase in value of the underlying asset (the car )

Now, as the seller of the car ( the writer of the contract option )you have no idea who will exercise the contract, which could have been bought and sold many times over during the 4 week period. But one thing is constant. If it is exercised, you will have to deliver the asset at the price agreed.It is a contract. This is how the options market works.

If we now look at some of the unique features of options these are as follows:The contract is for a specified time, normally 4 weeks, but there are options called LEAPS which extend for years. As there is a specified time, this is a wasting asset. If you buy an option it will be worthless in 4 weeks if not exercised. Each has an agreed contract price fixed for the life of the option. This is based on the underlying asset ( the share ). The option carries a premium. This is paid to the seller of an option by the buyer and is always kept by the seller. CALL options increase in value as the underlying asset increases, whilst PUT options increase as the underlying value of the asset decreases.

OK, lets just recap the above. When you buy an option the purchase price is called a PREMIUM. If you sell an option, the premium is the amount you receive. As a buyer you have rights, but no obligation. As a seller you have an obligation to deliver the terms of the contract. An option seller is also called a WRITER. Options are a derivative product, they are derived from something else. Equity options are derived from the equities market so the underlying asset is the share or stock price. The premium will vary minute by minute, up and down as the underlying value of the asset changes in the cash market. Options are leveraged instruments and therefore higher risk. Most equity options are 'Physical Delivery' which means that shares must change hands if the contract is exercised. Now one last point before we move on and it is simply this - as an option writer (seller ) you do of course have one choice - you can buy yourself out of the obligation by buying the contract back - this will naturally cost you more if the premium has increased in value! ( if the premium has decreased you may want to close out the contract for a small profit, or just leave it to expire for 100% profit on the premium ) As you can see from the above, the same option can be bought and sold many times before it is either exercised or expires worthless. Whatever happens, the option seller keeps the premium received from the initial buyer 1. As you can imagine all this trading has to be tightly controlled to ensure that buyers and sellers are matched correctly, and that contracts are fulfilled by sellers. In the UK, the options exchange is called LIFFE ( London International Financial Futures and Options Exchange ) and this is where all equity options are managed and traded. In the US there are several exchanges, but the principle ones are CBOE ( Chicago Board of Options Exchange ), AMEX and Philadelphia Exchange. Everything to do with trading, managing and exercising the options is conducted by the exchanges. You do not have to worry about actually doing anything - it all happens automatically. So if, for example, you have sold a call, and the contract is exercised, this will all happen automatically and the broker will transfer the shares out of your account at the agreed contract price and replace with cash. Finally there are two 'styles of options' - American style and European style. American style options can be exercised at any time as in our example above, whilst European can only be exercised only at expiry. Most equity Options will be American style but please check and make sure beforehand.

Whilst the terminology of equity options may seem strange at first, it is worth the effort. In their simplest form they can simply be bought and sold like any other financial instrument. Remember however that these are assets with a time value, they cannot be held for long periods as they all have an expiry date as part of the contract. Many traders simply buy and sell options throughout the trading day, making their money from the increase or decrease in the options value. Others use them in combination with the underlying stock to write calls. There are many ways to benefit from an understanding of these sophisticated instruments and I would urge you to dip a toe in the water!