Options are standard financial instruments that are used to speculate or reduce risk. They are not usually listed on the Exchange. Still, They have become popular recently in Singapore with the listing of options on blue chips, including DBS, Singtel, and ST Engineering (“You may be surprised how many listed options there are in Singapore”).
Seven frequently asked questions.
Option trades involve a significant risk of loss and may not be suitable for all investors. Please read the Characteristics and Risks of Standardized Options before proceeding further. This note is not an offer or solicitation to buy/sell securities. No representation is made that any account will or is likely to achieve profits or losses similar to those discussed herein. Past performance is not indicative of future results.
1) How do I calculate the intrinsic value of an option?
The intrinsic value is the difference between the underlying price and the strike price. Call options have a positive intrinsic value if the underlying price is higher than the strike price. There is a positive intrinsic value if the underlying price is lower than the strike price for put options.
2) What is an option spread?
Option spreads involve buying one option and selling another to lock in potential profits or reduce potential losses. A bull spread involves buying a call with a higher strike price and selling the same number of calls with a lower strike price to profit from an increase in the underlying stock. A bear spread involves buying puts with a lower strike price and writing (or selling) puts with a higher strike price to profit from a decline in the underlying stock.
3) What are OTC contracts?
OTC contracts are contracts between two parties, not on the Exchange. They can be exercised early by paying the exercise cost (like American style). As they are not allowed to be exercised early, their prices typically have more time premium built into them as traders need to compensate for this loss of flexibility (and choice). It makes them more expensive than the Exchange but less risky if held to maturity.
4) What is a digital option?
Digital options can only be settled in cash and never in physical delivery of shares, unlike most other types of opportunities. A European digital with a strike price of $50 cannot settle at an expiry above or below that price but will have a value equal to its intrinsic value (the difference between the underlying price and the strike price).
5) What is an attribute?
Attribute options are options with unique features that affect only certain parties to the option. For example, American or Bermudan style options can be exercised anytime during life until expiry, while European style options can only be exercised. The owner of a Bermudan style call option can choose not just any time to exercise but also which elements of his contract should be exercised if he wishes to do so. This choice is known as ‘attributes’. He could choose to exercise only the delivery element should he believe that prices will rise in the future without worrying about missing out on favorable stock prices at other times during his contract.
6) What are ‘at the money’ options?
The money options have a strike price equal to their underlying asset price. The alternative is said to be “on the money”.
7) When determining a call option’s intrinsic value and time premium, do I need to consider dividends?
No. You can think of an option as separate from its underlying stock for these purposes. Dividends do not affect the intrinsic value or time premium. These refer to changes in interest rates and other factors such as volatility, seasonality, etc., which dividends affect only marginally. Since most dividend-paying stocks tend to deliver higher returns due to their extra income stream, you can expect it might increase the chances of the option finishing in the money and thus increase its overall time premium.
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