What Are Call Options?
For many years, publicly owned companies have provided payment to upper level executives in the form of options to purchase shares of stock in the company for whom they were employed at discounts from the prevailing market price. These stock options are attractive for many reasons.
For one, the option is a form of deferred payment that provides certain tax benefits and allows the individual to control the times during which the income is derived. In addition, the opportunity to buy stock in the company is an additional incentive to the option recipient to work to increase the value of the company, and so also the value of the stock options. Early forms of option plans were limited in scope and available only to a handful of key executives. Indeed, the use of options as a form of compensation was routinely limited to the officers of a corporation, while the remaining employees were either granted stock pursuant to pension plans or, more often than not, were unable to participate in company sponsored ownership.
As alternative forms of compensation grew in popularity, companies were increasingly interested in providing payment to select employees in untraditional forms. Concepts such as flex time, position sharing, benefit tailoring, and others became the terminology of personnel departments for mechanisms to address staffing needs in a cost efficient manner. More recently, companies are examining the possible broader use of stock option-based compensation to cover greater numbers of employees in order to stretch out staffing dollars and to provide remuneration to employees in a form particularly desired by many staff members.
Although greeted with substantial enthusiasm, the problems in implementing a company sponsored stock option plan are daunting. As the number of participants grows, tracking salient data becomes increasingly complex. For the most part, companies are not equipped to handle the transactional attributes of stock option processing on a scale above a handful of participants. Each of the options or each block of options for each grant to each participant in the plan must be individually tracked for proper delineation of such parameters as the granting, vesting, exercise, and expiration dates, and the particular strike price for which the option right was granted.
Also, the practical exercise of an option requires the use of a brokerage house and an established exchange for trading and consummating the options and the underlying security in accordance with the plan attributes. The complexities of option account processing increase disproportionately when more than one company is involved; this is especially true for multinational companies working within the borders of multiple countries, each with its own set of legal requirements on stock ownership and tax consequences for resident employees.
Heretofore, there has been an absence of processing capabilities available to address the management of a multi-country, multi-company stock option account compensation plan for a plurality of individual accounts. In addition, stock option plans for multinational corporations, or for multinational employees i. Besides currency differences, from the participant's point of view there can be significant uncertainties over how to exercise options because options may be granted in qualified i.
It would be beneficial to the participant if he or she could simulate various financial outcomes e.
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Using the Black-Scholes model, the price of a call option can be expressed using the following formula:. This formula was the first theoretical model for calculating the fair value of a call option, and Black and Scholes were awarded the Nobel Prize in Economics over twenty years after the model was first published. Today the Black-Scholes formula is in use daily by thousands of traders to value option contracts traded in markets around the world.
The Black-Scholes pricing formula, along with other theoretical option pricing models, calculates the fair value of an option in part by assuming that fair value will be the price someone would pay in order to break even in the long run. The model employs several parameters that can affect the value of an option, the most important of which are the price difference between the underlying instrument and the strike price of the option, the volatility of the underlying instrument's return, and the time to expiration of the option.
Some of the more interesting and important ones are listed below:. With FLEX options the user can select customizable contract terms, and once a custom contract has been selected and there is open interest in that contract, the exchange will continue to trade contracts with those identical terms as a series until the expiration time of the custom option. With FLEX options, the terms of the contract that can be customized are the contract type calls or puts , expiration date with certain exceptions , exercise style American or European , exercise price and contract size.
When a user selects a new custom contract, a Request for Quote RFQ is entered into the system and market makers will respond with a quote for that contract. Once there is open interest in a certain contract, that contract will be traded until expiration of the option, with certain limits on contract sizes.
FLEX options give the user the advantage of customizable terms and an available secondary market for resale of purchased options to close out positions before expiration. Combinations of economic transactions using options can sometimes result in interesting positions in the underlying market. For example, a bull call spread is a well-known option combination that involves buying a call option and selling a call option with a higher strike price where both activities have the same expiration date.
This combination of events has the effect of limiting gain and loss if the underlying stock or commodity moves a large amount from its original price at the time the spread was created. However, the open spread position will still be moderately profitable with a moderate price gain in the underlying security. A bear call spread is the opposite of a bull call spread, where the call that is sold has the same expiration date but a strike price lower than the call that is bought.
The net effect is the same, except the position is profitable in the case of a limited price drop instead of a price gain. Another type of option combination is a time spread or calendar spread. A time call spread is similar to the bull call spread or the bear call spread in that calls are both bought and sold, but the options that are bought and sold in this case have the same strike price but differing expiration dates.
A long time call spread is entered by purchasing a call and selling a call with the same strike price but different expiration dates. The short option will expire first, and it is at this expiration time where the position typically has its highest value. It can be noted that although call spreads were discussed here, similar effects can be had using puts instead of calls, and the strategies do not differ substantially with the exception of the direction of profitability with underlying price movement.
Another type of option position is the synthetic long or the synthetic short position.
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A synthetic long position is created by buying a call of a particular strike price and expiration, and simultaneously selling a put with the same strike and expiration. This can be seen by considering the following: if the synthetic long position is entered with a strike price of 30, and if the underlying price moves above 30, the trader will want to exercise the call to buy the underlying instrument at the strike price. Conversely, if the underlying price moves below 30, the call becomes worthless, but the buyer of the put on the other side of the trade will undoubtedly want to exercise the put, which obligates the trader to buy at the strike price of In either case, once the options expire, the trader ends up buying the underlying instrument at the strike price for a synthetic long position, or selling the underlying instrument at the strike price for a synthetic short position.
In both the synthetic long position and the synthetic short position, it is rare for the underlying security to trade exactly at the strike price when the option position is purchased, and as a result the premium for the option bought will usually differ, sometimes substantially, from the premium for the option sold.
This means that although the premiums may largely cancel each other out premium sold canceling premium bought in terms of cash out-of-pocket , there may be a residual debit or credit to the trader's brokerage account due to the inequality. In addition, arbitrage opportunity may be present if the difference in premium for the options plus the strike price does not equal the price of the underlying instrument. There are many other types of options positions that can be entered into, some involving a combination of different options.
Depending on the trader's perception of the market and the price behavior of the underlying security, an appropriate option strategy can be selected, enabling the trader to customize his option portfolio according to his needs.
Account Options
This flexibility creates an important advantage in the trading of options as opposed to directly buying or selling combinations of the underlying instrument. The delta of an open option position is the amount that the option's price will change in accordance with a one-point change in the price of the underlying.
Vega is a measure of the option's sensitivity to volatility. Theta gives the sensitivity to time-to-expiration. Rho and gamma give the option price sensitivity to interest rates and the amount of change in the delta for a small change in the underlying instrument, respectively. Each of these parameters is a measure of the sensitivity of the option's price to changes in the underlying instrument.
Each is an important measure of option price sensitivity.
How Options Expiration Affects Stock Prices
Futures contracts, like option contracts, also have an underlying security, commodity, good or service. The buyer of a futures contract agrees to accept delivery of the underlying on the expiration date of the contract, and the seller of the futures contract agrees to deliver the underlying at expiration. Futures contracts, unlike their underlying instruments that have limited availability, can be infinitely replicated with opposing positions having the effect of canceling and negating each other.
Unlike option contracts, futures contracts do not have a strike price and as such, the value of a futures contract will typically be formed on the basis difference to the price of the underlying instrument. Forward contracts on an underlying instrument are contracts that mature at a certain date and time but for which settlement the actual transfer of ownership of the underlying instrument takes place at a separate and distinct time in the future.
Forward contracts do not have the same flexibility as futures contracts and are not readily transferable in a secondary market. They often represent a transaction effected between two consenting counter parties as a bilateral trade. Traders may choose how much they wish to pay, i. The advantages of a CFD are that market participants can choose their buy-in price, and they provide a leveraged investment vehicle.
The disadvantages of CFDs include potentially losing much more that was risked. The presently described technology relates to inventions concerning systems, methods and apparatus enabling short-term options to be traded, enabling traders to take advantage of price movements in an underlying instrument. The system offers high leverage short-term trading opportunities that involve options and option combinations. The described technology achieves this by utilizing a unique method of standardizing the qualities of an option contract.
Instead of using standardized option contracts with fixed strike prices and fixed expiration dates, the described technology standardizes options based on relative times and relative prices. An implied underlying price is then derived from any available option prices that, in turn, can be used to replace prices in underlying assets generated by external institutions and methods.
The described technology creates a self-contained option marketplace that can exist and operate independently of other markets. Certain terms are defined within the field of practice described herein, and these terms should be readily understood. To appreciate the presently described technology and inventions included therein, the present system of trading options must be considered. The existing system for trading options on an exchange involves the concept of standardization.
Standardization in the prior art refers to the setting of discrete calendar time and price intervals for the expiration date and strike price for option contracts listed on the exchange. One of the primary reasons for standardization is to concentrate trading in standard option contracts in order to increase liquidity. A second reason for the current method of standardization is to guarantee a marketplace where there is a way to close out open positions by selling back an option that was previously purchased. Other reasons for standardizing option contracts on an exchange include advantages offered by price transparency, price discovery and dissemination market participants are able to see what prices are available in the market to a certain level of market depth and the prices of previous transactions and price competition the best price in the market will be traded first.
Option contracts with underlyings that are securities, commodities, futures, market indices, currency pairs, exchange rates, other derivatives or other goods or services will work equally well with the systems, methods and apparatus of the invention. In the scope of this discussion it should therefore be understood that underlyings, or underlying goods or instruments, for option contracts may be any good, service, security, commodity, market index, derivative or other purchasable or tradable item of value or other asset. With the prior art systems for trading options on an exchange, once a specific underlying stock, security, commodity, etc.