02 May 2008

Options Are Standardized Contracts

There are two types of option, call options and put options.

The owner of a call option has the right, but not the obligation, to buy a certain amount of shares, at a certain price, on or before a certain date.

The owner of a put option has the right, but not the obligation, to sell a certain amount of shares, at a certain price, on or before a certain date.

In a nutshell, the owner of a call has the right to buy, and the owner of a put has the right to sell.

Options have been traded on all sorts of things for centuries, and on stocks for several decades. But these were non-standard contracts, the terms of which were individually negotiated by the parties involved.

In the US in the early seventies, to expedite the efficient trading of options contracts, the Options Clearing Corporation (OCC) was formed to facilitate the trading of options between stock market participants. The mechanics of how the OCC operates does not concern us in this section and I suggest you find out the activities of the options clearing house in the country in which you live. For the sake of international neutrality, I’ll use the term options clearing house (OCH) as a generic term. Suffice to know that they are operating in the background with the following benefits to option traders:

  1. Options contracts are standardized.
  2. Options exchanges were formed for the trading of these contracts
  3. Market Makers were enlisted to guarantee liquidity
  4. Facilitated the process known as “novation”.

N.B. Novation is the process whereby the person who you entered the contract with, does not have to be the person whom you conclude the contract with. This is another mechanism that ensures liquidity.

Let’s look at the standardization of option contracts. Each option contract will have the following features as set by the OCH

  1. The underlying instrument (e.g. the share the option is on)
  2. Whether the option is a put or call.
  3. The size of the contact. That is the number of shares contained in one contact. The standard contract size of US stock options is 100 shares, but please note that this may vary due to corporate actions during the lifespan of the option. (E.g. share splits etc.)
  4. The exercise price (or strike price as it is sometimes called): This is the price you have the right to buy or sell at, no matter what the market price is.
  5. The expiry date: This is the date up until which you have the right to buy or sell. After this date the option ceases to exist.

American or European

One further distinction, options contracts are classified as either American style, or European style, and refers to when it is possible to exercise your right to buy or sell.

An American style option can be exercised at any time up until the expiry day. Generally options on individual stocks and futures are American style.

A European style option is only able to be exercised upon expiry and cannot be done so beforehand. Some options on broad based indices are European style.

A Couple of Quick Examples

First a call option: The “MA April 18, 2008 220 call option”, an American style option, gives the owner the right, but not the obligation, to buy 100 shares in MasterCard Corporation, on or before April 18 2008, for $220.00 per share.

If MasterCard is trading at, lets say $250 at expiry, you are sure going to exercise your right to buy, if however it is trading at $170 at expiry, you’re sure not going to pay $220 for it and you will let it expire without exercising your right to buy.

Next the put option: The “FSLR May 16, 2008 195 put option” an American style option gives the owner the right, but not the obligation, to sell 100 shares in First Solar Inc. on or before May 16, 2008, for $ 195.00 per share.

If I own FSLR shares which are trading at $160 and I also own the above put option, it makes sense that I might exercise that right and get $195 for shares trading at $160, but if it’s trading at $210, I am not going to sell at $195.

Note that waiting till expiry and either exercising or not, is not your only alternative. You can trade out of the option if that suits your trading plan, but more on that later.

Next - Two Sides To An Options Contract

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