Call and Put options

Call options

Call options give the buyer the right (but not the obligation)

to buy the underlying stock at a specified price on or before a

specified date (expiry date). The price specified in the option

contract is referred to as a strike price or exercise price.

As a buyer of call options, you are hoping for the value

of the underlying stock to rise. An increase in the price of

the underlying stock will result in an increase in the value of

your options.

The seller of call options receives a premium for taking

on the obligation to sell the underlying stock to the buyer of

the options at the strike price if the buyer decides to exercise

the option before expiry. If the buyer exercises the option, the

seller must sell the underlying stock to the buyer at the strike

price. If the buyer does not exercise the option, the seller

simply retains the premium and the obligation expires with

the option on the expiry date.

Example 1.1

Let’s say BHP has a current market price of $44 per share. You believe

the market value of BHP will rise in the next few months. In order to

take advantage of this expected price rise, you decide to buy a $44

call option over BHP.

This gives you the right to buy 100 shares of BHP at the strike price of

$44 any time before the expiry date. If the value of BHP rises to, say,

$46, your options will increase in value by $2 less a component for

expired time value (we discuss this later).

You have a choice (or the option!) to either sell your option for a profit or

purchase the BHP shares for $44, $2 below their current market value

Put options

Put options give the buyer the right (but not the obligation)

to sell the underlying stock at a specified price (strike price)

on or before the expiry date. As a buyer of a put option, you

are hoping the value of the underlying stock will fall as this

will result in an increase in the value of your options.

The seller of a put option receives a premium for granting

this right to the buyer. If the option is exercised, the option

seller must buy the underlying stock at the strike price

Put options are a little harder to understand, as you will

make a profit if the value of the underlying stock falls. You

are also buying a right to sell an asset which you may or may

not own. Let’s run through the purchase of a put option in

example 1.2.

Example 1.2

CBA has a current market price of $52 per share. You believe the

market value of CBA is too high and will fall in the next few months.

You decide to buy a $52 put option over CBA.

This gives you the right to sell 100 shares of CBA at $52 any time

before the expiry date. If the value of CBA falls to, say, $50, your

options will increase in value by $2 less a component for expired time

value (we discuss this later).

You have a choice to either sell your option for a profit or, if you own

100 CBA shares, you can sell your CBA shares for $52 per share, $2

above their current market value.

Option contracts

Option contracts for exchange traded options contain

standard terms and conditions. Each option contract specifies

the following four components for any exchange traded

option:

1.  the underlying security
2.  the contract size
3.  the expiry date
4.  the exercise price (or strike price).

The option premium is not part of the standard terms of

the option contract as the option premium is variable and is

primarily determined by the market value of the underlying

security and the time left to expiry.