Purchasing or Selling Options

Lesson

Options are financial instruments that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date. This technique can be used for various purposes, such as hedging, speculation, or income generation.

Practice Question #1

Which of the following best describes a call option?

Terms

Long Call Option:

A long call option is a financial strategy where an investor buys a call option, giving them the right (but not the obligation) to purchase a security at a specified price before a specific date.

Short Call Option:

A short call option involves an investor selling or "writing" a call option, obligating them to sell a security at a specific price if the option is exercised.

Long Put Option:

A long put option allows an investor to buy a put option, granting them the right (but not the obligation) to sell a security at a specified price before a certain date.

Short Put Option:

A short put option involves an investor selling a put option, which obligates them to buy a security at a specified price if the option holder exercises it.

Writing Call Option:

Writing a call option refers to the act of selling a call option, which obligates the writer to sell a specific security at a predetermined price if the option buyer exercises it.

Writing Put Option:

Writing a put option involves selling a put option, obligating the writer to buy a certain security at a predetermined price if the option is exercised by the buyer.

Practice Question #2

What does it mean for an option to be in-the-money?

Historical Example

In the late 1970s, options trading gained popularity as a way for investors to hedge their portfolios against market fluctuations. This led to the establishment of the Chicago Board Options Exchange (CBOE) in 1973, which became the first marketplace for standardized options contracts.

Practice Question #3

Which of the following is NOT a purpose for using options in portfolio management?

Real-World Example

An investor believes that the price of a stock will rise in the next three months. They purchase a call option with a strike price of $50 and an expiration date in three months. If the stock price rises above $50 before the expiration date, the investor can exercise the option and buy the stock at the lower strike price, potentially making a profit.

Rhyme

Options give the right, not obligation, to buy or sell, With calls and puts, strike prices, and dates, as we'll now tell. Hedging, speculating, or income, they serve, But remember, the premium's the price that you'll pay to reserve.

More Detail

- Long call option risk: The risk associated with buying a call option, which gives the buyer the right, but not the obligation, to purchase an underlying asset at a specified price before the option expires. The risk is limited to the premium paid for the option. - Short call option risk: The risk associated with selling a call option obligates the seller to sell the underlying asset at a specified price if the buyer exercises the option. The risk is theoretically unlimited, as the underlying asset's price can rise indefinitely. - Long put option risk: The risk associated with buying a put option, which gives the buyer the right, but not the obligation, to sell an underlying asset at a specified price before the option expires. The risk is limited to the premium paid for the option. - Short put option risk: The risk associated with selling a put option obligates the seller to buy the underlying asset at a specified price if the buyer exercises the option. The risk is the full value of the underlying asset, as it can fall to zero.

More Detail Examples

- Long call option risk example: An investor buys a call option for $5 with a strike price of $50. The maximum risk is the $5 premium paid for the option. - Short call option risk example: An investor sells a call option with a strike price of $50. If the underlying asset's price rises to $100, the seller faces a loss of $50 per share (minus the premium received). - Long put option risk example: An investor buys a put option for $3 with a strike price of $40. The maximum risk is the $3 premium paid for the option. - Short put option risk example: An investor sells a put option with a strike price of $40. If the underlying asset's price falls to $10, the seller faces a loss of $30 per share (minus the premium received). - Writing call options example: An investor sells a call option with a strike price of $50, obligating them to sell the underlying asset at $50 if the buyer exercises the option. - Writing put options example: An investor sells a put option with a strike price of $40, obligating them to buy the underlying asset at $40 if the buyer exercises the option. - Breakeven example: An investor buys a call option for $5 with a strike price of $50. The breakeven point is $55 ($50 strike price + $5 premium).

Pitfalls to Remember

- Long call option risk pitfall:

The option may expire worthless if the underlying asset's price does not rise above the strike price, resulting in a total loss of the premium paid.

- Short call option risk pitfall:

The potential loss is theoretically unlimited, as the underlying asset's price can rise indefinitely, exposing the seller to significant risk.

- Long put option risk pitfall:

The option may expire worthless if the underlying asset's price does not fall below the strike price, resulting in a total loss of the premium paid.

- Short put option risk pitfall:

The potential loss is substantial, as the underlying asset's price can fall to zero, exposing the seller to significant risk.

- Writing call options pitfall:

The seller may be obligated to sell the underlying asset at a lower price than the current market price, resulting in a loss.

- Writing put options pitfall:

The seller may be obligated to buy the underlying asset at a higher price than the current market price, resulting in a loss.

- Breakeven pitfall:

Breakeven calculations do not account for transaction costs, taxes, or other fees, which may affect the actual breakeven point.