An option is a contract to buy or sell an underlying asset or security at a specified price on or before a given date. While institutional investors have long been users of options – and growth continues in this segment – we have seen a growing usage of options strategies by individual investors to leverage their positions with less capital and bolster portfolio returns. In this primer from SIFMA Insights, we provide a fundamental overview of U.S. listed options, including:

• Mapping Options Strategies
• Drivers of Market Volumes
• Evolution of the Market Landscape
• Classes of Options
• Fun Facts on Options
• The History of U.S. Options Exchange and Market Events

Executive Summary

An option is a contract to buy or sell an underlying asset or security (stocks, ETFs, etc.) at a specified price on or before a given date. With an equity option, the contract holder (buyer) has the right, but not the obligation, to buy/sell (if a call/put) shares of the underlying stock. The writer (seller) of an option is obligated to sell/buy (if call/put) the shares to/from the buyer of the option at the specified price upon the buyer’s request.

Contracts are detailed, and terms include strike price (price the contract may be exercised, or acted on) and an expiration date (point in time the option no longer has value, or no longer exists). Options are frequently used as a risk management tool by investors to hedge positions and limit portfolio losses. For example, an individual investor can buy a put as insurance to protect a stock holding against an unfavorable market move, while maintaining stock ownership.

Options provide flexibility, enabling an investor to tailor their portfolio to investment objectives and market environment, including:

• Protect from a decline in stock prices;
• Arrange to buy a stock at a set lower price in the future;
• Position the portfolio for expected market moves, even if direction of the move is unpredictable;
• Protect against sudden market movements and reversals, such as experienced with the 2010 Flash Crash;
• Boost portfolio returns without the costs or capital outlay of buying the individual stock (the initial investment is limited to the price of the option contract premium); or
• Generate income against stock holdings in your portfolio

As a standalone investment, most options strategies limit the risk to an investor but also present unlimited profit potential (depending upon whether the investor is the buyer or seller of the options contract). Options transactions also typically require less capital than single stock trades. For example, an equity option allows an investor to lock in the price at which he/she can buy/sell 100 shares of stock, paying only the premium or price of the option contract.

This leverage enables investors to increase the potential benefit from stock price movements(1):

• Stock purchase: Buy 100 shares of a stock priced at $50 = 100 * $50 = $5,000 total investment
• Call option: A call option with a $5 premium and a strike price of $50 = $5 * 100 (the option gives the holder the right to buy 100 shares) = $500 investment per option contract
• The stock price increases to $55
  • Stock purchase: Gain on the investment = $55 / $50 – 1 = 10%
  • Call option: With the increase in the underlying stock price, the premium increases to $7. Gain on the investment = $7 / $5 – 1 = 40%

While the initial capital outlay is less and the gain on investment is higher when the stock price increases, leverage also comes with a potential downside:

• The stock price decreases to $40
  • Stock purchase: Loss on the investment = $40 / $50 – 1 = -20%
  • Call option: With the decrease in the underlying stock price, the premium decreases to $2. Loss on the investment = $2 / $5 – 1 = -60%
  • Note, an option buyer’s loss will be limited to the premium paid for the option contract

While institutional investors have long been users of options – and growth continues in this segment – we have seen a growing usage of options strategies by individual investors to leverage their positions with less capital and bolster portfolio returns.

(1) Source: Options Industry Council

SIFMA Insights Primers

The primer series from SIFMA Insights goes beyond a typical 101-level brief, breaking down important technical and regulatory nuances to foster a fundamental understanding of the marketplace and set the scene to address complex issues arising in today’s markets.

See our full series here.

Authors

SIFMA Insights

Katie Kolchin, CFA
Senior Industry Analyst

Options

Ellen Greene
Managing Director