What can options do for me?
- Manage the Risk Exposure within your portfolio.
- Let you profit in a falling market, while limiting your risk.
- Profit in a flat market.
- Reduce risk in your portfolio, while positioning yourself to profit when the market moves.
What is an option?
An Option is a contract between two investors, a buyer and a writer. The buyer has the option to buy or sell stocks at the strike price, any time until the expiry date.
There are two types of options, Calls & Puts. A call option gives the buyer the right to buy the underlying asset, and a put gives the buyer the right to sell the underlying asset. The buyer of a call would expect the stock price to rise, and the buyer of a put would expect the price of the stock to fall.
What price should I pay the bid or the ask?
If you are buying an option you pay the ask price and if you are selling an option you will sell it for the bid price. If you try to buy an option for less than the ask price or try and sell an option for more than the bid price your order will only get filled if the price of the option moves.
Where do options come from?
Stocks and bonds are issued by the company as a way of raising capital, however options are not issued by the company they are based on. Options are a contract between two investors, therefore the options contract is actually issued by the investor that is writing (selling) the options contract. The exchange specifies the terms of each option contract but they don't actually issue them.
How is an option exercised
An options holder has the right but not the obligation to exercise their options. The exercise process is started by the option holder contacting their broker and telling them to exercise the option. Next the broker will issue an exercise notice to the clearing corporation who will then issue an assignment notice to a firm that has a client who wrote that same option. The firm then forwards the assignment notice to one of there client accounts which wrote that option. The client who wrote the option will see an order go through their account to buy or sell the stock at the strike price, this trade is done with the options holder who exercised the option. After the option is exercised the option disappears because the rights granted under the option have already been used up.
Can I chose any strike price or expiry date?
No. Exchange traded options have been standardized by the exchanges to improve liquidity. This standardization is done in the contract size, strike prices and expiry dates.
In North America the contract size is typically 100 shares per contract.
The exchange standardizes the strike prices by choosing three strike prices; one in-the-money, one at-the-money, and one out-of-the-money. As the price of the underlying stock moves the exchange will list more strike prices so that they continue to have one contract in-the-money, one at-the-money, and one out-of-the-money.
The Exchange also standardizes the expiry date, this will be the Saturday following the third Friday of the expiry month. The last trading day is the third Friday of the expiry month. The exchange will also decide which months to have option contracts listed for.
What if the option writer doesn't fulfill their obligation?
Exchange traded options are guaranteed by the clearing corporation (the OCC in the US). The clearing corporation becomes the buyer to every seller and the seller to every buyer. This is called the principle of substitution, the clearing corporation becomes your substitute counterparty. When a trade is matched there are actually two contracts created, one between the buyer and the clearing corporation, and one between the clearing corporation and the writer.
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