Options contract fundamentals and drafting

¶ … Contracts: An Examination

Nearly everyone who is even vaguely familiar with the stock market is familiar with the expression, "buy low and sell high." However, the issue with that method is that it is only effective in one kind of market -- bull markets. Options are a means of expanding one's trading strategy and allowing there to be a higher amount of profit from market patterns. Options allow one the possibility to profit regardless of the direction that stocks take: they have the ability to help one to cut losses, protect one's gains and to control a more massive amount of the stock market with a smaller amount of cash at the outlay. Thus, options can offer versatility, but with a certain amount of risk. The key to minimizing one's risk really revolves around the ability to truly understand all the nuances connected with options so that one's understanding is completely rock solid.

Options Defined: What are Options?

An options contract refers to an agreement which is made between a buyer and seller which allows the person buying the option the strict right to buy or sell a specific asset at a later date for a price which is specific and agreed upon. Such contracts are often used in securities, commodities or business dealings. Essentially, options are forms of contracts where the seller gives the buyer the opportunity, but not the obligation, to purchase or sell a specific number of shares at a set price within a set time period.

"Options are derivatives, which means their value is derived from the value of an underlying investment. Most frequently the underlying investment on which an option is based is the equity shares in a publicly listed company. Other underlying investments on which options can be based include stock indexes, Exchange Traded Funds (ETFs), government securities, foreign currencies or commodities like agricultural or industrial products" (Nasdaq.com). Options are also traded on securities marketplaces among institutional investors, individual investors, and professional traders for single contracts or for numerous ones. The following elements can help in defining an options contract: type, security, unity of trade, strike price and expiration date (nasdaq.com).

Why Use Options

One major reason to purchase options is to hedge. Put options can ultimately pay off and be a truly effective form of insurance for one's overall portfolio: "And in true supply demand fashion, when optimism reigns, the price of put option insurance goes down (insurance is cheapest when no one wants it)" (Fischer, 2010). Using options to hedge means that you have a means of hedging against any potential decline. Furthermore, as an additional bonus, when the market turns contrary, one can sell the puts back into the market for profit when insurance is all of a sudden in a higher demand, offering stock to potentially bounce back. "On a more granular level, you can also use a strategy called a collar to protect individual stocks that you own during uncertain times. Worried that Dell's upcoming earnings announcement will be poorly received? Sell a call option for every 100 shares owned, with a strike price a buck or two higher than the current share price, and then use the proceeds to buy a put a buck or two below the current stock price -- with both options expiring after the expected earnings date, you can set up your protective collar for little or no cost" (Fischer, 2010). In such an example, one is protected against the stock price plummeting beneath the put strike price, but this level of defense does arrive at the price of giving up the benefits in the stock price beyond the call strike.

Another means of using options is to speculate. One can think of using options in this manner as a means of placing a bet on the direction a movement of a security is going to make (investopedia, 2014). This offers a distinct benefit in that one thus isn't limited to generating a profit only when the market rises. This means that as a result of the versatility of options, one isn't bound to making a profit only when the market rises. The versatility of options means that one can also make money when the market plummets or even moves sideways.

Speculation refers to the territory where one can acquire intense profits or lose such massive profits. "The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option; you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen" (investopedia, 2014). Thus all of these components, in conjunction with the commissions involved, mean that using options in this manner is a rather high risk venture. Even so, options offer versatility and leverage when controlling profits and shares.

Types of Options

Several types of options contracts generally abound in financial transactions; for instance, an exchange traded option is settled via a clearing house and has a guarantee attached to it (IA, 2014). These types of options encapsulate stock options, commodity options, bond and interest rate options, index options and other such rewards (IA, 2014). Yet another variety of option contract is the over-the-counter option which is traded between two parties in a manner which includes interest ration options, currency exchange rate options and means of swapping so that either long or short-term interest rates are received (IA, 2014).

American vs. European Options

One of the major differences between American vs. European Options is that the former can be used whenever; on the other hand, a European options can be used only at its specific expiration date. Thus, American options offer an enhanced level of flexibility and potential. "Thus, we can say American Options = European Options + Premium where the Premium is greater than or equal to zero" (Harvard.edu).

Calls and Puts

Standard options actually only come with two specific varieties: call options and put options. Many experts agree that having a basic understanding of the differences between these two options is essential before getting started. "For each call contract you buy, you have the right (but not the obligation) to purchase 100 shares of a specific security at a specific price within a specific time frame. A good way to remember this is: You have the right to 'call' stock away from somebody" (Tradeking, 2014). Likewise, for every contract bought, one has the right, but not the obligation to sell 100 shares of a specific security, at a set price within a set time frame: thus, one has the right to "put" stock to someone. In this sense, one also needs to bear in mind that commissions also apply, with their cost being factored into the decision process.

Long-Term Options

If used wisely, investing in long-term options can have a real pay-off: "The potential loss of 100% of capital invested also means that they should only be used in the rare circumstances where the upside potential is significant" (investopedia, 2014). Thus, this highlights both the potential for loss and for gain when it comes to investing in options: though the risk is at times significant, the reward is as well.

Exotic Options

Exotic options refer to non-standardized options with specific conditions placed upon them so that they are better able to help the individual investor with issues which are generally traded over the counter (Jason, 2014). In a similar fashion, exotic options contain two broader categories: standardized and non-standardized. Standardized options often get the term "plain-vanilla options" a generally typical when it comes to the options traded over stock exchanges. Non-standardized options are the ones which come with special standards and conditions, making them more ideal for specific investor needs (Jason, 2014).

How Options Work

"The main features of an exchange traded option, such as a call options contract, provides a right to buy 100 shares of a security at a given price by a set date. The options contract charges a market-based fee (called a premium). The stock price listed in the contract is called the "strike price. At the same time, a put options contract gives the buyer of the contract the right to sell the stock at a strike price by a specified date. In both cases, if the buyer of the options contract does not act by the designated date, the option expires" (IA, 2014). Thus, a basic call options contract might mean that a trader anticipates that the ABC Company's stock will go up to $100 in the next month. In this manner, the trader is able to see that he can purchase an options contract of this company at $5.00 with a strike price of $70 per share. The trader must pay the cost of the option ($5.00 x 100 shares = $500). The stick price starts to rise as expected and then stabilizes at $110: before the expiry date on the options contract, the trader can engage in a call option and purchase all the shares of the company's stock at $70, the strike price on the options agreement. The trader pays $7,000 for the stock and can sell the new stock on the market for $11,000, making a profit of $4,000.

Call vs. Put / Seller vs. Buyer

As this paper has already stated, options one the ability, without an obligation, to engage in a security at a set price within a particular time period. With a call option, the buyer has the right, though is not required to buy at a set quantity of a commodity or a financial instrument from a seller by a particular expiration date for a certain price. On the other hand, a put option is the right to sell the underlying stock at a given strike price by a particular date. "The party that sells the option is called the writer of the option. The option holder pays the option writer a fee -- called the option price or premium. In exchange for this fee, the option writer is obligated to fulfill the terms of the contract should the option holder choose to exercise the option" (diffen.com).

When things are more volatile, the call premiums are larger, and are thus better for writing, because one earns more income when the volatility is high (Greg, 2011). With higher prices of options, investors are more fearful: "If someone has to pay a lot of money for an option above its intrinsic value, then the VIX is high. The general rule is that option premiums are high when the VIX is over 30" (Greg, 2011). On the other hand, a good time to purchase a put on a stock that one owns is when one has made a solid gain, but if one's level of certainty isn't that stable regarding the act of cashing out: puts can help in protecting against short-term volatility in long-term holdings (dummies, 2012). In the first example, one's put option helps to act as an insurance policy to help act defensively regarding one's gains. The latter example, if one's put goes up in value, one can sell it, decreasing the paper losses on one's stock: one can ultimately decide which put option to purchase by determining how much profit prospective one is okay with losing if the stock increases (dummies, 2012). Another term which is widely used is the term regarding "selling naked"; this is comparable to buying a call option, as it allows one to accrue more money when the underlying stock increases (dummies, 2012). Thus, this means that one is able to sell the put option without shortness in the stock and in the journey; one is able to hope that the stock stays at the same price or rises which will allow one to maintain the same premium (dummies, 2012).

Things to Consider

However, there are still things to consider when purchasing an options contract: "When you purchase an options contract, you pay a premium for the privilege that goes along with holding that contract; you're not paying for the full value of a stock. For instance, if you wanted to commit some of your investment capital to Google (GOOG), you'd be paying in the neighborhood of $625 a share. Buy 500 shares and that investment is the equivalent of a piece of real estate…" (Moon, 2012). While it's still possible to play the market in this fashion, it's not always the most ideal way as it can sometimes be very expensive. There's still a way to play Google and a range of other sticks with a much smaller initial investment along with a greater likelihood of getting return which can equal and sometimes even exceed what the average investor might experience. Options in this fashion can help to open the door to an even greater variety of equities and ETFs for capitalized investors that might not otherwise be able to have such expensive stocks in their portfolios (Moon, 2012).

Options Contract in the Stock Market

On the other hand, many argue that options contracts are crucial in helping to offer traders the opportunity to weigh their stock positions, allowing for a more leveraged position on a stock while mitigating the entire risk of the full purchase: in a likewise fashion, in real estate, such a contract can empower a buyer to gain a hold of options contracts on a range of parcels before having to execute the purchase on a single one, thus, making sure that the buyer will be able to put them all together before moving forward (IA, 2014).

Options Contract in the House Market

One can argue that when it comes to the house market, option selling is one of the most important customer services and profit endeavors available. When the housing market is creaks to a halt in the slow season, "savvy builders use their design centers to entice prospective home buyers. The community sales person, in anticipation of selling the customer a home, sends them to the design center to preview the exciting option program. The design center becomes a critical component of the customer experience and an essential tool for raising profit" (Gullo, 2014). Thus, options within the housing market often manifest as display, design or selling options. Within the housing market this can also manifest as customization, allowing those who invest to make one of a kind customizations and designs. This can help investor increase the value of their initial investment.

Benefits of Options

Even though there are definitive and concerted risks involved in using options, there are also some pretty specific and marked benefits. Options, when used well, have the ability to help one protect investments against declining market prices, while increasing one's income on current or new investments. Equity can be bought at a lower price, and the benefit from an equity price's rise or fall can be regardless of whether one owns the equity or sells it outright (nasdaq.com).

Another major benefit of options contracts are that they create orderly, efficient and liquid markets with high amounts of flexibility: "Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and/or other financial instruments to seek profits or protection" (Nasdaq.com). This means that equity options give investors the ability to set prices for specific periods of time during which investors can buy or sell 100 shares of a given equity for a premium, which ends up being only a percentage of what one would pay to own the equity outright; this gives option investors the ability to leverage their upper hand while increasing the prospective reward from an equity's price fluctuations (nasdaq.com).

Certain other investments might offer risks without boundaries; options trading offers the clear benefit of a set and defined risk to buyers: an option buyer cannot lose more than the price of the option, which is known as the premium. "Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the option contract are not met by the expiration date. An uncovered option seller (sometimes referred to as the uncovered writer of an option), on the other hand, may face unlimited risk" (nasdaq.com).

Disadvantages of Options Contracts

However, these tools are not with their own marked disadvantage. Options contracts are known for having a markedly lower liquidity: this is a result of the fact that many specific stock options don't actually encounter much volume in their lifespan: thus, given the fact that each stock which proves optionable will have different strike prices and expirations, indicates that the specific option that one possesses might in fact be at a very low volume unless it is one of the most popular stocks or indexes (thinktrade.net). However, small traders won't be bothered by this lower amount of liquidity, if they're just trading low numbers of contracts.

Options contracts are also known for possessing higher spreads as a result of the "…lack of liquidity. This means it will cost you more in indirect costs when doing an option trade because you will be giving up the spread when you trade" (thinktrade.net). Options trading also encompasses higher commissions which will cost one more in commission per dollar invested: these commissions could be found to be even higher for spreads where one has to pay commissions for both sides gathered (thinktrade.net).

Options are also exceedingly complicated to beginners and they really do take a long time to understand fully and for achieving mastery. Options trading also possesses a certain amount of time decay: one loses the time value of the options as one holds them; unfortunately there's no real way to get around this rule (thinktrade.net). Options are also trickier to deal with as it can be more difficult to get standard quotes about them or other such basic analytical information which will give hints about the implied volatility or other issues. It's also worth noting that options just aren't available for all stocks, thus limiting the amount of possibilities out there.

Chicago Board Options Exchange

The Chicago Board Options Exchange is the largest options market in the world, as it is able to capture the bulk of the options that are traded at all. The company is located at 400 South LaSalle Street in Chicago with around one billion contracts traded annually at the end of 2007. Within the CBOE, there are around 2,200 companies involved, a particularly remarkable feat if one considers how CBOE was only established as early as 1973. The Securities and Exchange Commission still oversees them and CBOE is still overseen by the Options Clearing Corporation (OCC). Just a decade ago, CBOE was able to open the trading on the Futures Exchange for volatility and variance, launching Reg NMS-compliant stock exchange, to compete with other major national stock exchanges, like NYSE and Nasdaq. One of the things which is distinctive about the way that trading occurs at CBOE is that it is carried out via exchanges, enabling customers to trade through an open outcry, with almost the bulk of the orders being traded electronically.

Suggestions for Beginners Trading Options

When it comes to trading options for beginners, it's absolutely essential that one keeps one's emotions in check: fear needs to be controlled as do all other destructive emotions. Above all else, one needs to have a plan to be in control of and to work that plan in a controlled fashion, regardless of what one's fears dictate.

One of the primary suggestions for beginners is that one needs to plan one's exit so that one can minimize loss on the downside, in case things go awry. "You should have an exit plan, period -- even when a trade is going your way. You need to choose your upside exit point and downside exit point in advance. But it's important to keep in mind, with options you need more than upside and downside price targets. You also need to plan the time frame for each exit" (optionsplaybook, 2014). Options are, above all else, an asset which is going to decay over time, and the speed at which it decays only gets faster as the date of expiration gets closer; this means that if one is long a call or if certain moves that one expected haven't happened yet, it's up to you to move on to the next trade, getting out of this negative situation as quickly as possible.

However, it's still important o be aware of the instances where time decay can work on your side: when one sells options without owning them, that means one is using time decay in a fashion where it can work for one's best interest (optionsplaybook, 2014). This essentially means that one can be successful, if time decay erodes the option's price, allowing one to keep the premium received for the sale. "But keep in mind this premium is your maximum profit if you're short a call or put. The flipside is that you are exposed to potentially substantial risk if the trade goes awry" (optionsplaybook, 2014). This means that one absolutely needs to have a plan to get out of any trade, regardless of the strategy one is running; waiting around on profitable trades can be too risky and can be largely motivated by greed.