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Introduction Derivatives

Terminology

Hedge

Hedging is an investing strategy where the market movement effects from a stock or a portfolio are offset by some other financial instrument. As an example, a stock portfolio can be hedged buy purchasing a Put Option over the S&P 500 index.

NASDAQ

National Association of Securities Dealers Automated Quotations (NASDAQ) which is the world's second largest stock exchange after NYSE. Companies that are listed on NASDAQ must meet strict regulatory requirements. Shares in these companies can be bought and sold through a Stock Broker. These stocks can also be bought and sold on ECNs.

NYSE

New York Stock Exchange (NYSE) which is the world's largest stock exchange. Companies that are listed on NYSE must meet strict regulatory requirements. Shares in these companies can be bought and sold through a Stock Broker. These stocks can also be bought and sold on ECNs.

Stock Broker

Stock Brokers electronically forward the buy and sell orders onto a Stock Exchange or to an ECN, whichever gives the stock investor or stock trader a better price.

An Overview of Options

Introduction to Derivatives - An Overview of Options; picture of a road sign with yellow background with black writing on it saying stock options just head for investors and traders

Options can provide investors with benefits, but care needs to be taken

An option is simply a contract to buy or sell a financial instrument such as a stock, commodity or currency. In effect, there are two types of option contracts.

Call Option: This is a contract to buy a financial instrument.

Put Option: This is a contract to sell a financial instrument.

For simplicity, stocks will be used as the financial instrument to illustrate what options are and how they work. The same principles apply to options over other financial instruments.

When an investor buys a call option they are actually buying a contract. This contract enables the investor to buy the stock at a future date at a fixed price that is stated in the option contract irrespective of what the stock's price is in the future. If the future stock price is not attractive, the investor is under no obligation to buy the stock. This is why they are called an option contract - the investor has the option to buy the stock. The investor does not receive a refund if the investor does not buy the stock.

All options contracts state the following information.

Option Contract information:

  • Call or Put: All options contracts state whether it is a call option or whether it is a put option.
  • Underlying: This is the company that the contract is over. For a call option, this is the stock that can be bought. For a put option, this is the stock that an investor can sell.
  • Strike: This is the price that the stock can be bought for with a call option or the price that the stock can be sold for with a put option.
  • Expiry date: All options contracts have a time limit that the contract is valid until. Once the expiry date has passed, the option contract is no longer valid.
  • Multiplier: This states how many shares the options contract includes. The majority of option contracts are for 100 shares. This means if an investor buys one call option, the investor can buy 100 shares.

Some examples of option contracts are shown below.

Option Examples: .

Contract Name: AAPL170519C00142000

  1. The Stock symbol is AAPL (which is obtained from the first letters of the contract name).
  2. The Option expiry is 170519 (the 6 digits following the stock symbol in the format YYMMDD) which for this contract is May 19, 2017.
  3. This contract is a Call Option (Determined by the letter following the expiry which for this contract is the letter "C").
  4. The strike price is $142.000 (Determined from the remaining digits which gives the strike to three decimal places).

Contract Name: V170721P00092500

  1. The Stock symbol is V (which is obtained from the first letter of the contract name).
  2. The Option expiry is 170721 (the 6 digits following the stock symbol in the format YYMMDD) which for this contract is July 21, 2017.
  3. This contract is a Put Option (Determined by the letter following the expiry which for this which for this contract is the letter "P").
  4. The strike price is $92.500 (Determined from the remaining digits which gives the strike to three decimal places).

The investor buys an option contract in exactly the same manner as buying stocks and most stock brokers are also options brokers. The options are not bought from NYSE or NASDAQ, but from a variety of options exchanges.

Introduction to Derivatives - An Overview of Options; picture of an animated contract depicting that stock options are an agreement between two parties

The price an investor pays for an option contract is known as the option premium and the investor can buy as many contracts as they wish. Options contracts can also be sold through an options exchange to another investor or market maker at any time before the options expiry date.

Should the investor decide to buy the stock, the investor must pay the Strike price multiplied by the number of shares (usually 100). This process is known as "exercise" and terminates the contract. Thus, once the investor buys the stock, a call option contract no longer exists and the investor can no longer sell their call option contract.

The value of an option contract varies from day to day and is dependant on the price of the stock that the option is over. Option prices are actually derived from a complex mathematical formula. Basically, a call option is worth more if the stock's price increases and a put option is worth more if the stock's price decreases.

When the stock price of a call option is above the strike price, the option's strike price is attractive to investors as they can exercise the call option and effectively buy the stock for less than the current stock price. When the stock price for a Call Option is above the strike price, Call Options are referred to as being "in-the-money".

When the stock price of a call option is below the strike price, the option's strike price is not attractive to investors since they can buy the stock from the stock market for less than the option's strike price. When the stock price for a Call Option is below the strike price, Call Options are referred to as being "out-the-money".

Option Examples: .

In-the-money Call Option MCD170519C00120000

  • McDonald's Corp. In-the-money Call Option with $120 Strike and option price of $16.60 with the stock price at $132.64 (April 19, 2017).

Out-the-money Call Option MCD170519C00145000

  • McDonald's Corp. Out-the-money Call Option with $145 Strike and option price of $0.04 with the stock price at $132.64 (April 19, 2017).

As the above example shows, the price of an option drops sustainably as it goes out-the-money. In fact it can be near impossible to sell out-the-money options as they approach their expiry dates. Despite this there are plenty of investors and traders willing to speculate that an out-the-money option will go into the money before its expiry.

Options still remain to be a popular contract and they do have a wide variety of uses other than merely speculating on the stock price increasing.

Investors might buy call options when they are concerned about the future price of the stock, such as an upcoming earnings announcement. Buying a call option, the investor can wait and see what happens to the stock's price. If in the future the stock's price has increased, the investor can simply exercise the option and buy the stock at the strike price. If the stock's price falls, then the investor has simply lost the amount paid for buying the option.

Similarly, investors might buy a put option as a hedging tactic if they are concerned about the future price of a stock they own. If the stock's price declines, the investor can exercise their put option and sell their stock for the strike price.

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