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Options

Options Explained

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2 Options | Scotia iTRADE

What are Options?

Options Explained

An option is a contract that gives the buyer the right, but generally not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

The two types of options are calls and puts:



A call

A call gives the holder the right to buy a specific amount of a certain asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.



A put

A put gives the holder the right to sell a specific amount of a certain asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Why Use Options?

Investors and Traders use options to:



Protect stock holdings from a decline in

market price



Earn income from current stock holdings



Prepare to buy stock at a lower price



Position for a big market move even when

they aren’t sure which way prices will move



Benefit from a stock price's rise or fall without incurring the cost of buying or selling the stock outright

Other benefits include



Efficient, Liquid Markets



Flexibility



Leverage



Limited Risk



Guaranteed Contract Performance

Options

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3 Options | Scotia iTRADE Standardized option contracts provide orderly, efficient, and liquid option markets. Except under special circumstances, stock option contracts generally cover 100 shares of the underlying stock. The strike price of an option is the specified share price at which the shares of stock will be bought or sold if the buyer of an option (the holder) exercises his/her option.

As a result of this standardization, option prices (premiums) can be obtained quickly and easily at any time during trading hours. Additionally, closing option prices for exchange-traded options are published daily in many newspapers. Option prices are set by buyers and sellers on the exchange floor, where all trading is conducted in the open, competitive manner of an auction market.



Flexibility

Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and/or other financial instruments to create either a hedged or speculative position.



Leverage

A stock option allows you to set the price, for a specific period of time, at which you can purchase or sell 100 shares of stock. To buy the right to control the stock in that way, you pay a price (the premium) which is only a percentage of what you would have to pay to own the stock outright. That leverage means that by using options you may be able to increase your potential benefit from a stock's price movements.

Option Buyer pays a premium and secures a right

Seller collects a premium and has an obligation

Seller’s Right Call To buy shares at a

specified price over a specific time period

To deliver shares at a specific price over a specific time period

Keeps the premium from selling the option

Put To sell shares at a specific price over a specific time period

To buy shares at a specific price over a specific time period

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Options Pricing

Understanding Options Pricing

The specific stock on which an option contract is based is commonly referred to as the

underlying security. Options are categorized

as derivative securities because their value is derived in part from the value and

characteristics of the underlying security. A stock option contract's unit of trade is the number of shares of underlying stock which are represented by that option. Generally speaking, stock options have a unit of trade of 100 shares. This means that one option contract represents the right to buy or sell 100 shares of the

underlying security.

Strike Price

The strike price, or exercise price, of an option is the specified share price at which the shares of stock can be bought or sold by the holder, or buyer, of the option contract if they exercise their right against a writer, or seller, of the option. To exercise your option is to exercise your right to buy (in the case of a call) or sell (in the case of a put) the underlying shares at the specified strike price of the option.

The strike price, a fixed specification of an option contract, should not be confused with the premium, the price at which the contract trades on the market, which fluctuates, based on market conditions.

In-the-Money

If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price that would have to be paid to buy the stock in the stock market.

Out-of-the-Money

If a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in-the-money because the holder of this put has the right to sell the stock at a price which is greater than the price that would be received for selling the stock in the stock market.

Out-of-the-Money and

At-the-Money

The converse of in-the-money is, not surprisingly, out-of-the-money. If the strike price equals the current market price, the option is said to be at the-money.

Premium

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5 Options | Scotia iTRADE exercised, the writer keeps the premium.

Premiums are quoted on a per share basis. Thus, a premium of $1.00 represents a premium payment of $100.00 per option contract ($1.00 x 100 shares).

Underlying Stock Price

The value of an option depends heavily upon the price of its underlying stock. If the price of the stock is above a call option's strike price, the call option is said to be in-the-money. Likewise, if the stock price is below a put option's strike price, the put option is in-the-money. The difference between an in-the-money option's strike price and the current market price of a share of its underlying security is referred to as the option's intrinsic value.

Only in-the-money options have intrinsic value. For example, if a call option's strike price is $45 and the underlying shares are trading at $60, the option has intrinsic value of $ 15 because the holder of that option could exercise the option and buy the shares at $45. The buyer could then immediately sell these shares on the stock market for $60, yielding a profit of $ 15 per share, or $ 1,500 per option contract When the underlying share price is equal to the strike price, the option (either call or put) is at-the-money. An option which is not in-the-money or at-the-in-the-money is said to be out-of-the-money. An at-the-money or out-of-the-money option has no intrinsic value, but this does not mean it can be obtained at no cost.

Time Value

The primary components of time value are time remaining until expiration, volatility, dividends, and interest rates. Time value is the amount by which the option premium exceeds the intrinsic value.

Option Premium = Intrinsic

Value + Time Value

For in-the-money options, the time value is the excess portion over intrinsic value. For at-the-money and out-of-the-at-the-money options, the time value is the option premium.

Time Remaining Until Expiration

Generally, the longer the time remaining until an option's expiration date, the higher the option premium because there is a greater possibility that the underlying share price might move so as to make the option in-the-money. Time value drops rapidly in the last several weeks of an option's life.

Volatility

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Dividends

Regular cash dividends are paid to the stock owner. Therefore, cash dividends affect option premiums through their effect on the

underlying share price. Because the stock price is expected to fall by the amount of the cash dividend, higher cash dividends tend to imply lower call premiums and higher put premiums. Options customarily reflect the influences of stock dividends (e.g., additional shares of stock) and stock splits because the number of shares represented by each option is adjusted to take these changes into consideration.

Interest Rates

Historically, higher interest rates have tended to result in higher call premiums and lower put premiums.

Read an Options

Quote

Options are widely quoted in the financial press. Although there may be differences in how the statistics are presented, invariably the option tables always focus on the same core information. To help us define terms, imagine the month is September and we're checking out option activity in our favorite newspaper.

Here is how one option quote might look for a fictional call on shares of a company known as ABC Inc.

ABC 10/18/14 20 Call



ABC

Underlying Security. The name of the particular security (or index such as OEX or TSX) that an investor has the right to buy or sell according to the terms of a listed option contract. This is known as the ‘underlying security’.



10/18/14

Expiry date October 18, 2014.

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7 Options | Scotia iTRADE November; and the third is March, June,

September and December.

Normally options expire on the Saturday following the third Friday of their specified month. In practice, however, this means that the third Friday is the last day you have to trade your option (some exceptions do exist).

The holder of an option has the right to buy or sell (depending on if the option is a call or a put) the underlying stock any time until the expiration date. In addition, option writers can terminate their side of the contract by buying to close at any time before the option expires.



20

Exercise or ‘Strike’ Price. The price at which the buyer may buy stock from the writer (in the case of a call) or sell stock to the writer (in the case of a put). In the example above, if the buyer exercises the option, he is guaranteed a price of $20 a share for ABC regardless of how high the price of ABC might rise before the expiration date.



Premium Price

The premium price is the market price of an option contract at a given time. When you purchase an option contract, you pay the premium price immediately. The premium quoted is for one option contract but because that contract covers 100 shares (known as the multiplier, usually 100 shares for stocks), you must multiply the premium dollar amount quoted by 100 to derive the actual cost of the contract. Thus, a $3 premium actually means one contract costs $300. Please note that option premiums fluctuate.



Call

Class There are two types of options, calls or puts, each is referred to as a class of options. All of the calls listed for the same underlying stock are one class and all of the puts listed for that stock are the other class.

Get an Options Chain

An Options chain is a form of quoting options prices through a list of all the options for a given security. It is a listing of all the call and all the put option strike prices along with their premiums for a given maturity period.

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8 Options | Scotia iTRADE You can also enter the desired stock, click on ‘Go’ and then select ‘Options’ from the submenu.

You will then have access to the Options chain. From here, you can select the following information:



Chain (Calls and/or Puts)



Sort by Month or Strike Price



Strike Price



Expiry



Option Type

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9 Options | Scotia iTRADE [Type a quote from the document or the summary of an interesting point. You can position the text box anywhere in the document. Use the Drawing Tools tab to change the formatting of the pull quote text box.]



Call Options can be found on the left, Put Options on the right



Shaded areas indicate In-The-Money Options



Click on ‘Analyse’ to access Options Greeks

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Invest in Options

Options trading can form an important part of a successful investment portfolio.

At Scotia iTRADE®, we give you the power to trade options easily and track the

ups and downs of the market.



Select Account



Select Options



Select Symbol or use magnifying glass

to search



Select Market



Select Option Type, i.e. call or put



Enter Expiration and Strike



Select Order Type, i.e. buy to open, sell

to close, sell to open

(covered/uncovered), buy to close

(covered/uncovered)



Enter number of contracts



Enter Price Type and Term

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To learn more about Options and Option Tools, join our

Webinars

or view our

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Mailing address

Scotia iTRADE

PO Box 4002 Station A Toronto, ON

M5W 0G4

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48 Yonge Street (Yonge/Wellington) Toronto, ON, M5E 1G6

Tel: 1-888-769-3723

Email: [email protected]

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