How Options are Structured

People who are looking to possess a certain security may want to do so at a future point in time, under the right conditions. This is what options provide us, an opportunity to perform a certain transaction when we take the buy side, and on the sell side, the obligation to fill a certain transaction if they buyer opts to exercise their option.

Options can be used to achieve quite a number of different purposes and are by far the most flexible type of security out there. An option can be used for as simple of a purpose as hedging one’s stock positions, they can be used to leverage movements in the price of an underlying security, options can be written to take advantage of sideways markets, or they can be combined to form some pretty complex strategies to seek to capitalize on various things.

It is the purpose of financial markets to provide a means to execute additional strategies which traders may be interested in, including trading various assets directly in addition to securities based upon the changing value of these assets.

Options are a type of derivative that is based upon the price action of something else, in this case the price of what is optioned to buy or sell with the options contract. The easiest way to understand options is that they consist of side bets on the value of something in the future, based upon how much the price will change of the optioned asset over a relatively short period of time.

These bets do serve some practical purposes though aside from just placing or laying these bets, which is to provide traders with the opportunity to hedge their positions, and hedging is one of the main uses of options.

They also allow traders to make the markets so to speak by backing the contracts that are sold in the market, called options writing, where they have the opportunity to take the other side of options trades, capturing the premium and underwriting the risk.

The Structure of Options Contracts

Options contracts are structured to provide the buyer of the option the option to exercise it at, or often before a set time where the option is set to expire. Options contracts consist of the opportunity to exercise it for a given amount of the asset being optioned, for instance 100 shares of a stock, which is standard for stock options. Options may also be bought for other types of assets such as indices, currencies, and futures.

It gives the option holder the right but not the obligation to buy or sell the designated quantity of the asset, e.g. 100 shares of a stock, at the designated price, called the strike price.

There are two types of options that you can buy, a call option which is designed to take advantage of upward movements of the underlying asset, and put options, which are bought to capitalize on downward price movements of the security optioned.

The writer of the option provides the other side of the trade, where they sell the option to the buyer, whether it is a call option or a put option. Even though put options are betting on the asset’s price declining, and we normally call that selling, or shorting, with options, it is the option writer or seller that is doing the shorting, since they are taking the short side of the option.

If you buy a call option, and it ends up being exercised, the writer of the option will need to provide the person exercising the option with the number of shares or units designated by the contract. This would occur when the price of the asset has exceeded the contracted price in the contract, or the strike price, in the direction of the option.

To illustrate this with a simple example, if you bought an option on XYZ with a strike price of $50, and the price went to $60, and the option cost you $5, you would have a net profit of $5 per share. The option seller would deliver to you the number of shares, presently worth $60 a share, by either transferring the shares they already own, or buying them on the market and giving them to you, for the contracted price, in this case for $50.

Their net loss would be $5 a share, the $10 it cost them to deliver them to you, less the $5 premium you paid for the option to do this.

If the price went down, or didn’t rise to the target strike price, it wouldn’t make sense for anyone to exercise it at a loss, so it would expire worthless and you would be out the $5 you paid for the option.

Option Risks

The risk to the option buyer is limited to the amount paid for the premium, as no matter what happens with the price of the asset, you cannot lose more than you spent to buy the option, which is one of the functions of options.

Losing your entire investment with an option is nothing to scoff at though, and this is one of the reasons why options are seen as more risky than other types of trading. One must be prepared to lose everything when buying options, although you don’t necessarily lose it all if your option doesn’t finish in the money so to speak, as they can be sold prior to that for a loss but one that is less than the entire premium paid.

Selling or writing options risks more dollar wise, as options writers are responsible for covering the entire move against them during the period of the options contract. Selling put options theoretically places the value of the entire security at risk, and selling call options theoretically has unlimited risk, limited only by the magnitude of the rise in price of the optioned asset.

This sounds pretty risky indeed, and it can be, but if the options writer already owns the security, then the losses can be offset by movements in the security itself, where you’d be giving up the profits you would have made if you didn’t sell the option. This is called covered options writing, where the options contract is covered by your owning the asset, and in the end you just give up your position in the underlying asset if needed.

Uncovered, or naked options writing, does not involve the options seller owning the security, and in this case, the risk can be significant, as any losses have to be covered by cash.

One of the biggest perceived risks of options writing is that they cannot just exit their position like they could if they owned the stock or other asset and it went against them too much, but there are other strategies that they can use to minimize this risk, including buying an option at a different strike price to cover the one they wrote if they felt the need to do so, transferring part of the risk to someone else in exchange for the premium.

In this case, their loss would be limited to the difference between the two prices less the premium, and one can even take both positions initially, selling and buying the same option contract. There are numerous ways to combine options and this can become very complex but it will suffice to say that the risk of options managing can be managed a lot better than many people think.

Premiums and Time Decay

When you buy an option, it has a certain value, expressed in the potential gain that may be achieved. This potential gain represents the risk to the seller, in which they must be compensated for taking on, otherwise it would not make sense to sell options.

This amount paid to the seller by the options buyer is called the premium. In our example, we would be paying the $5 to the options seller for the right to buy the stock at $50 later.

Options, like other derivatives, are structured as a zero sum game, due to their expiry. In the end, one side makes money, and the other side loses the same amount, net of trading costs on both sides.

This causes us to strive for a level of equilibrium as far as the money made on each side, otherwise either buying or selling options would not be sustainable long term. If people lost money too often by selling options for instance, then this would drive away options sellers, or options buyers if they lost too much money on buying them.

This does not mean that particular options traders can’t make money over the long run either buying or selling options, and many traders do. As is always the case with trading, the money flows from the less skilled to the more skilled over time, just like it would in a poker game.

The pricing of premiums is complicated and relies on fairly complex mathematical models to determine them, taking into account the elements of the options contract, the implied volatility,  the time decay.

Since options premiums are paid in compensation for taking risks, the amount of risk involved in a particular scenario is going to drive the price. The more volatile a security is, the more risk that will be present, and the higher the premium must be.

As well, the more time to expiration, the more risk there will be, and therefore time serves to both set the premium and decay it so to speak, where each day typically represents less risk and the price becomes affected.

This does not mean that the price or the premium for an option will continue to go down as it matures, as this is just one of the factors, and the movement of the price of the optioned asset itself is of course the main factor. Time and volatility also play a role in this though in setting the price of options both initially and on a day to day basis as the option is traded on the market.

As complex as options trading can be, and it can be quite complex indeed, it need not be so, although options trading is certainly more complicated and difficult than trading anything else and options traders in particular need to ensure they have a good enough grasp of them to allow for their success.