INVESTING TERMS
What are
LARGE
An option is a derivative contract in which an investor has the right, but not the obligation, to buy or sell a tradable asset at a specified
price at a given time in the
future. They are very similar
to futures contracts, except
that they are “optional,”
hence the name; futures
involve the obligation to buy
or sell an underlying asset.
Deeper definition
The party who creates an option contract is said to write the option, and charges the other party a fee, or a premium, to enter the contract. The writer of an option commits to buy or sell an asset at a preset price, called the strike price. The option is considered live until an expiration date, when it terminates. The writer must buy or sell a security if it reaches the strike price, when the holder can exercise the option, but if the expiration arrives before the strike price is reached, the writer keeps the premium and no exchange takes place.
Options example
This infographic was designed by Avalaunch Media
There are a variety of different kinds of options, including:
OPTIONS?
In practice, fewer than
10 percent of options are
ever exercised, while the
vast majority are either
traded or expire worthless.
The price of the premiums
charged for options fluctuate
as the value of the underlying securities change, and the contracts are resold on exchanges like the Chicago Board Options Exchange (CBOE), giving investors the ability to get leverage and speculate on the direction of trading in the underlying assets.
SHORT-TERM
CAPITAL GAINS
Profits made from selling assets owned for one year or less.
LONG-TERM
CAPITAL GAINS
Profits made from selling assets owned for more than one year.
Jeff bought a vacation home for $100,000 and used it as a rental property for five years before selling it for $150,000, giving him a capital gain of $50,000.
Since he owned the property for more than one year, he calculated his long-term capital gain based on his tax bracket.
Since his annual income placed him in the 15 percent tax bracket ($37,651 to $91,150 for a single person in 2016), he didn’t have to pay any taxes on the profit.
If Susan pays only the minimum payment of $20 per month, it will take her 11 months to pay off her balance.
EBITDA doesn’t need to be measured by the Securities and Exchange Commission’s accounting standards, the Generally Accepted Accounting Principles (GAAP), so it is not a required line item on a company’s financial statement. EBITDA has become much more common in recent years, although many firms list an adjusted EBITDA figure.
Englebert has a portfolio of stock that includes hundreds of shares of Dynaco Machines Corp. In order to boost his income, he writes call options on his favorite stock, Dynaco, and sells them on the CBOE. Dynaco is currently trading at $125 a share, so Englebert writes a call option that gives the holder the right, but not the obligation, to purchase 100 shares of Dynaco at a strike prices of $150, with an expiration date three months out. Englebert is charging a premium of $2 per share (x100 = $200) to buy the option.
Before the proliferation of
inexpensive computer
technology, it had been very
difficult to create and price
complicated derivative contracts, but this problem was more or less solved by the 1990s, thanks also to the Black-Scholes equation. Mortgage-backed securities became very common investment products. Instead of using derivatives to effectively balance risk, institutional traders began buying them up as ways to create leverage and take on much more risk. When the U.S. housing market began to crumble in 2006 and 2007, MBS investments spread throughout the banking system began to rapidly lose value, precipitating the crisis.
MARKET CAP
VALUE
OUTSTANDING SHARES
SHARE PRICE
OF THE STOCK
Calls are the opposite. Holders have the right, but not the obligation, to buy assets if the strike price is reached before expiration. With calls, the holder thinks the asset’s price will rise above the strike price.
The measure can be calculated by taking a company’s net income and adding back interest expense, taxes, depreciation, and amortization. Alternatively, it can be calculated by taking a company’s operating profit — EBIT, or earnings before interest and taxes — and adding depreciation and amortization.
Susan opens a credit card with a $1,000 credit limit and an interest rate of 14.99.
She makes a purchase of $200.
Susan understands she will pay interest on the balance until she pays it off, but she decides to carry a revolving balance.
If Susan pays only the minimum payment of $20 per month, it will take her 11 months to pay off her balance.
If shares of Dynaco rise
above $150, the buyer of
the options wins and
Englebert is obligated to
sell 100 shares to the
holder for $150. But if they
never hit the strike price of $150, Englebert wins and gets to keep the $200 premium the buyer paid. If shares of Dynaco get closer to the strike price of $150, the buyer can resell the option and make a profit off his speculative bet, but if shares of Dynaco decline — widening the spread between the strike price and the underlying asset price — the price of the option falls.
$100 million
$2
$20 million
$10 million
– Minus
PRICE PER SHARE
EXPENSES
Equals =
$30 million
NET PROFIT
>$10B
Investors use derivatives such as options and futures to manage risk, to speculate and to obtain leverage. They are “derived” from an underlying asset. With options, the underlying asset is most often stock, although they are also used to trade currencies, bonds and ETFs, among other securities.
x
=
$10 Billion
PRICE/SHARE
MARKET CAP VALUE
NOT A LARGE CAP COMPANY
OUTSTANDING SHARES
PRICE/SHARE
MARKET CAP VALUE
A LARGE CAP COMPANY
=
63,000,000
$200
$12.6 Billion
Weekly options
Mini-options
Index options
Binary options
Options on Futures
ES Weekly options
E-Mini options
ETF options
Options contracts come in two categories:
Puts give the holder who buys the option the right, but not the obligation, to sell assets to the writer of the option once the agreed-upon strike price is reached. With puts, the holder believes the underlying asset’s price will fall below the strike price before expiration.
1. Puts
2. Calls