Options explained part 2; options settlement

Options explained part 2; options settlement

In my previous articles “options explained part 1; what are options? And how do options work?” I started explaining the basic knowledge required for trading options. In this second version of “options explained” I focus more on the settlement of options, which is absolutely critical to know if you ever want to trade options.

Topics that will be discussed in this article:

  • American style or European style
  • Exercise & Assignment
  • In-the-money, at-the-money, out-of-the-money

American or European style options trading

Various types of options are traded on financial markets. The most common option types are American style and European style. There is one major difference between the two: the way the option is settled. American style options are physically delivered. This means that the underlying shares will be delivered on the expiration date.

With a European-style option there is no physical delivery, but cash settlement, the value of the option is settled in cash on the expiry date. With American style options, it is possible to exercise prematurely (early exercise). This means that the holder of the call or put option can exercise his right at any time (i.e. even before the expiration date).

All stock options listed on the Amsterdam stock exchange are American-style options, which can be exercised prematurely.

Exercise & assignment

The two relevant terms related to the settlement of options are exercise and assignment. When an option is exercised, the shares are delivered at the strike price.

The option trader pays the exercise price to the counterparty that delivers the shares. This counterparty, the writer of the option, will receive an assignment and delivers the shares to the exerciser. This process happens at random. The party with whom you entered into the transaction in the first place, is not necessarily the party that delivers to you.

Open interest with options trading

Unlike stocks, where the number of outstanding shares is basically fixed, options do not have a limit to outstanding contracts on an underlying asset. The number of option contracts depends on the market demand. If a trader/investor buys a call option, for example, the number of outstanding call options of the respective option series increases. The total number of outstanding options contracts per option series is called open interest. After opening a new option position, the open interest will therefore increase with the number of options purchased.

Moneyness

The term moneyness refers to the ratio of the exercise price of the option to the price of the underlying asset. When the strike price of a call option is below the current price of the underlying asset, the option is in-the-money. For a put option, the option is in-the-money if the strike price is above the current price. The premium of in-the-money options is composed of intrinsic value and a bit of expectancy value.

An option the strike price of which is equal to the price of the underlying is at-the-money. With an at-the-money option the premium doesn’t have intrinsic value and is composed entirely of expectation value. A call option whose strike price is above the current price, is called an out-of-the-money option. A put option is out-of-the-money if the strike price is below the current price. The premium of out-of-the-money options is also entirely composed of expectation value.

 

Type In-the-money At-the-money Out-of-money
CALL Price > strike price Price = strike price Price < strike price
PUT Price < strike price Price = strike price Price > strike price