What is an Option?

Definition

An option is a contract that gives the buyer the right to either buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a pre-determined price by a specific date.  Options are a powerful tool for creating a wide array of payoff profiles and can be used on a standalone basis or integrated into a broader portfolio strategy.  
 

History

Options began trading shortly after the New York Stock Exchange opened in 1791, but back then options were only traded “over the counter” (OTC), where broker-dealers negotiated custom agreements between buyers and sellers.  In 1973 we saw the birth of “listed” options with the establishment of the Chicago Board Options Exchange (CBOE) and the Options Clearing Corporation (OCC), whereby options with preset terms could be traded efficiently without the counterparty risks associated with OTC contracts.  Today there are approximately $65 trillion in exchange-traded options outstanding by notional principal value.¹
 

How Are They Traded?

Listed options can be bought and sold throughout the trading day during regular trading hours on qualifying stocks, ETFs, indexes, and futures contracts.  Like stocks, option order types include market, limit, and stop loss order variations.  Typically, one option contract will provide the right to buy or sell 100 shares of the underlying instrument.  Though options positions are usually purchased at a single strike price and expiration date, constituting what is known as a single option “leg”, investors and traders can combine legs across different strikes and expirations to create custom-tailored potential outcomes.
 

Use Cases

Options are used for three primary purposes: hedging, speculation, and income.
 

• Hedging with options is typically accomplished by buying a put option to protect an existing underlying position against a decline in price.  This form of hedging can be thought of as buying insurance to mitigate a potential risk event.
• Speculative trading on the other hand typically begins with a directional view on an asset, with no pre-existing positions in the asset to be concerned with.  In this instance, a trader would buy a call or put to potentially capitalize on a move up or down, respectively, while limiting the capital outlay to just the cost of the option.
• Income generation is typically accomplished by selling call options on a stock or index that is already owned, generating income that is equal to the call premium while simultaneously capping the potential upside of the underlying asset since it could be acquired by the option holder at the strike price if price rose significantly.

 

Tax Treatment

Stock and ETF options share tax treatment similarities with stocks and ETFs but also have a few points of distinction.  Like a stock, when a stock option is purchased it incurs a cost basis that is reflective of the amount paid for the position.  Additionally, when a stock option is sold for a gain or a loss, a long or short-term capital gain or loss is attributed to the trade based on the respective holding period.  Unlike a stock, however, options that are not exercised or sold before expiration will expire at $0, generating a loss upon the expiration date.  Additionally, options on equity indices receive the “60/40” tax treatment, whereby regardless of holding period any gains are taxed as 60% long-term gains and 40% short-term gains.
 

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¹ Data from the Bank of International Settlements as of March 31, 2020.