Stock options

Stock options are the most common equity derivative. They are traded both on the stock exchange and on the over-the-counter (OTC) market. Options give their holder (the buyer) the right, but not the obligation, to settle the underlying instruments in the future. Simply put, a stock option serves as a "warrant" to buy or sell shares at a future date, at a predetermined price and in a predetermined quantity. The price at which the buyer has the right to buy or sell the underlying asset is called the option's strike price or strike price. Since the seller of the option is at a disadvantage, he receives a so-called option premium from the buyer.

Characteristics and prevalence of stock options

There are two types of options:

• Call options, where the option holder is "long" and has the right to buy the equity instruments from the seller within a specified time period (the option holder becomes the new owner of the shares).
• A put option, where the holder is also long but has the right to sell the equity instruments within a certain period of time.

Stock options can be further divided into American and European. The difference between the two is the exercise of the option from the time of purchase (put) to the time of expiry (call). A European option can only be sold or bought during its term, but not exercised. It is only exercised at the time of expiry. In contrast, we can sell, buy and exercise an American option at any time during its term, so we do not have to wait until the expiration date.

Option premium

The option premium is the price at which the option holder acquires from the writer the right to terminate the contract. The option premium plays a crucial role in deriving the profits and losses from the option. The most important factor determining the amount of the option premium is the market interest rate. The holder of a call option pays only the strike price for the underlying shares at the time the call option is exercised. Until then, he does not need the funds for the purchase and can therefore lend them, which earns him remuneration in the form of interest. A rise in market interest rates is beneficial to call option holders, so the price of the call options, i.e. their option premium, rises.

For put options, the effect is not unidirectional. The holder of a put option must theoretically buy the underlying shares and hold them until the option is exercised. He cannot lend his funds as they are tied up and thus loses the interest income. An increase in the market interest rate therefore leads to a decrease in the put option price.

The option premium is made up of two components:

• the intrinsic value of the option - it corresponds to the profit the holder of the option would make if he exercised it immediately and sold it on the market at the same time
• the time value of the option - it reflects both the monetisability of the option and the volatility of the share. The time value of an option decreases as the expiration date of the option approaches. The time value increases when market volatility increases.

Monetisation of the option

Stock options can also be classified according to the exercise price. There are three variants:

• The first is an out-of-the-money (OTM) position, where the strike price is higher than the current market price. We expect the price of the underlying asset to rise above the strike price and we will make a profit. Buying an option in this position is the cheapest for us compared to the following options. The seller charges a lower option premium because it is more likely that the market price at maturity will not be above the strike price. There is an inverse relationship: the greater the difference between the strike price and the market price, the lower the option premium for the seller.
• The second option is called the at-the-money option (ATM), where the strike price is equal to the market price.
• The third option is the in-the-money option (ITM), where the purchase is the most expensive of all options for us. The strike price is already in a range where we would make a profit at maturity, i.e. below the market price of the underlying.

These examples apply to the purchase of a call option. For the purchase of a put option, the situation would be reversed.