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10.5 Options

A comprehensive guide to understanding call and put options, their positions and strategies, and how market participants utilize options.

Call and Put Option Positions and the Option Strategies Used by Market Participants

An option is a contract between two parties: a buyer (known as the long position or holder) and a seller (known as the short position or writer). This contract gives certain rights or obligations to buy or sell a specified amount of an underlying asset at a specified price within a specified time. The buyer of the option has the right, but not the obligation, to exercise the terms of the contract, whereas the seller is obliged to fulfill their part of the contract if called upon to do so.

Types of Options

  1. Call Option: An option that grants the holder the right to buy the underlying asset and imposes the obligation on the writer to sell the asset at the predetermined price.

  2. Put Option: An option that grants the holder the right to sell the underlying asset and imposes the obligation on the writer to buy the asset at the predetermined price.

Below is a detailed breakdown of the positions and expectations for both call and put options.

Table 10.2 | The Four Basic Option Positions

Position Call Option Put Option
Holder - PAYS premium to the writer
- Has the RIGHT to BUY the underlying asset at the predetermined price
- Expects the price of the underlying asset to RISE
- PAYS premium to the writer
- Has the RIGHT to SELL the underlying asset at the predetermined price
- Expects the price of the underlying asset to FALL
Writer - RECEIVES premium from the buyer
- Has the OBLIGATION to SELL the underlying asset at the predetermined price, if called upon to do so
- Expects the price of the underlying asset to REMAIN THE SAME OR FALL
- RECEIVES premium from the buyer
- Has the OBLIGATION to BUY the underlying asset at the predetermined price, if called upon to do so
- Expects the price of the underlying asset to REMAIN THE SAME OR RISE

Key Phrases in Options Trading

When traders and investors discuss options, they usually describe the specific option they are referring to by summarizing its most salient features in one phrase. The general syntax used is:

$$ \text{Number of Option Contracts} + \text{Underlying Asset} + \text{Expiration Month} + \text{Strike Price} + \text{Option Type} $$

Example

An investor wants to buy 10 exchange-traded call options on XYZ stock with an expiration date in December and a strike price of $50. The investor states, “I want to buy 10 XYZ December 50 calls.”

As with buying a stock, the investor must indicate the price they are willing to pay. They can buy the options at market value, accepting the best price currently available, or they can enter a limit order by specifying the highest price they are willing to pay.

Frequently Asked Questions

Q1: What is an option premium?

A1: The option premium is the price that the buyer of the option pays to the seller (writer) for the rights granted by the option.

Q2: What happens if an option expires and is not exercised?

A2: If an option expires and is not exercised, it becomes worthless. The holder loses the premium paid, whereas the writer keeps the premium received.

Q3: Can options be traded on margin?

A3: Yes, options can be traded on margin, allowing investors to use borrowed funds to purchase options, thereby amplifying their potential gains and losses.

Key Takeaways

  • Call Option: Right to buy; obligation to sell.
  • Put Option: Right to sell; obligation to buy.
  • Holder: Pays premium; has a right.
  • Writer: Receives premium; has an obligation.

Glossary

  • Option: A financial derivative that provides buyers the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a set timeframe.
  • Call Option: Gives the holder the right to buy an underlying asset.
  • Put Option: Gives the holder the right to sell an underlying asset.
  • Option Premium: The price paid by the buyer for the option.
  • Holder: The buyer of the option.
  • Writer: The seller of the option.
  • Strike Price: The predetermined price at which the underlying asset can be bought (call) or sold (put).
  • Expiration Date: The date on which the option contract expires.

By understanding these components and terms, market participants can effectively use options to hedge, speculate, or enhance their portfolios.


CSC® Exams Practice Questions

📚✨ CSC Exam Questions ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck!

## What does a call option grant the holder the right to do? - [ ] Sell the underlying asset at a specified price - [x] Buy the underlying asset at a specified price - [ ] Sell the option itself at any price - [ ] Buy additional options without a premium > **Explanation:** A call option grants the holder the right to buy the underlying asset at a predetermined price within a specified period. ## In an option contract, who has the obligation to fulfill the contract if the option is exercised? - [ ] Holder - [x] Writer - [ ] Both holder and writer - [ ] Neither holder nor writer > **Explanation:** The writer (or the seller) of an option contract has the obligation to fulfill the contract if the option is exercised by the holder. ## What is the expected price movement of the underlying asset for the holder of a call option? - [x] Rise - [ ] Fall - [ ] Stay the same - [ ] Fluctuate > **Explanation:** The holder of a call option expects the price of the underlying asset to rise, as this allows them to buy the asset at a lower price than its market value. ## What does the writer of a put option expect the underlying asset’s price to do? - [ ] Rise - [x] Remain the same or rise - [ ] Fall - [ ] Fluctuate significantly > **Explanation:** The writer of a put option expects the price of the underlying asset to remain the same or rise, since they are obligated to buy the asset if the holder exercises the option. ## What happens when an option holder buys at market price? - [x] The holder accepts the best price currently available - [ ] The holder sets the highest price they are willing to pay - [ ] The holder buys at the lowest historical price - [ ] The holder specifies a future date to finalize the transaction > **Explanation:** When an option holder buys at market price, they accept the best price currently available in the market. ## If an investor wants to buy 5 call options on ABC stock to expire in March with a strike price of $60, how would they phrase their request? - [ ] "I want to buy 5 ABC calls expiring in March for $60." - [x] "I want to buy 5 ABC March 60 calls." - [ ] "5 calls for ABC stock expiring in March at 60." - [ ] "ABC stock, March calls, 5 contracts at 60." > **Explanation:** The phrase "I want to buy 5 ABC March 60 calls" follows the convention used to describe option contracts, systematically summarizing the number of contracts, the underlying asset, expiration month, and strike price. ## What is the premium in an options contract? - [x] The fee paid by the holder to the writer for the rights conveyed by the option - [ ] The transaction cost for executing the trade - [ ] The extra margin required to cover potential losses - [ ] The commission paid to the broker > **Explanation:** The premium in an options contract is the fee paid by the holder to the writer for the rights conveyed by the option. ## Which option type gives the right to sell the underlying asset? - [ ] Call option - [x] Put option - [ ] Long option - [ ] Short option > **Explanation:** A put option gives the holder the right to sell the underlying asset at a predetermined price within a specified time. ## What does the holder of a put option expect the underlying asset’s price to do? - [ ] Rise - [x] Fall - [ ] Stay the same - [ ] Rapidly fluctuate > **Explanation:** The holder of a put option expects the price of the underlying asset to fall so that they can sell the asset at a higher strike price compared to its market value. ## What role does the number of option contracts play in an option's description? - [ ] It determines the expiration date - [ ] It indicates the strike price - [ ] It specifies the underlying asset - [x] It denotes the volume of options being traded > **Explanation:** The number of option contracts specifies the volume of options being traded, indicating how many contracts are involved in the transaction.

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In this section

  • 10.5.1 Options Terminology
    Gain a thorough understanding of essential options terminology including strike price, option premium, expiration date, trading unit, and other key concepts.
  • 10.5.2 Option Exchanges
    A detailed guide on option exchanges in Canada, including explanations of key terms, examples, and the structure of equity option quotes.
  • 10.5.3 Option Strategies For Individual And Institutional Investors
    Understand the various option strategies used by individual and institutional investors, including detailed examples and calculations for trading call and put options on XYZ Inc. Learn speculative and risk management approaches, and the potential outcomes of different trading strategies.
  • 10.5.4 Option Strategies For Corporations
    Learn about different option strategies that corporations employ to manage risk related to interest rates, exchange rates, and commodity prices.
Sunday, July 21, 2024