Lesson in Clarity: Option Contract

Alibaba’s initial public offering (IPO) was the largest in history, drawing attention from the media and investment industry alike. Many focused on how the Chinese eCommerce giant’s shares would perform. But there was also considerable interest in Alibaba options. Why?

In this article, we take a closer look at a key topic in the Investment Foundations course of study—option contracts (Module 3)—to understand industry and investor interest in Alibaba options.

What Are Options?

With an option contract, the buyer has the right, but not the obligation, to buy or sell the underlying asset or security, such as a share in Alibaba. But the seller of the option, also called the “writer,” has an obligation because the buyer’s actions determine the seller’s actions. In other words, if the buyer decides to use (or exercise) the option, the seller is obligated to satisfy the option buyer’s claim; if the buyer decides not to exercise the option, it expires without any action by the seller.

The terms of the option contract itself will specify the price to trade the underlying in the future (which is called the exercise price or strike price) and the expiration date of the option. Option contracts typically expire in March, June, September, or December. A buyer chooses whether to exercise an option based on the underlying’s price compared with the exercise price. A buyer will exercise the option only when doing so is advantageous compared with trading in the market, which puts the seller at a disadvantage. Because of the unilateral future obligation (only the seller has an obligation), options have positive value to the buyer at the beginning of the contract. The option buyer pays this value, or premium, to the option seller at the time of the initial contract. The premium paid by the option buyer compensates the option seller for the risk taken; the option seller is the only party with a future obligation.

Option Types

There are two basic types of options: options to buy the underlying, known as call options, and options to sell the underlying, known as put options. An investor who buys a call option has the right (but not the obligation) to buy the underlying at the exercise price until the option expires. An investor who buys a put option has the right (but not the obligation) to sell the underlying at the exercise price until expiration.

An Example

Consider a call option in which the underlying is 1,000 shares of Company A trading on the London Stock Exchange (LSE). The call option’s exercise price is £6.00 per share, which means that the call option holder can buy 1,000 shares of Company A at £6.00 per share until expiration of the option, regardless of Company A’s share price in the market. Note that the buyer of this option will exercise this option only if Company A’s price on the LSE is more than £6.00 per share.

Therefore, if Company A’s share price at expiration of the option is £7.00 per share, the buyer exercises the option (remember the contract is for 1,000 shares), pays £6,000, and receives 1,000 shares of Company A; the buyer can then sell those shares in the market for £7,000 and make a profit of £1,000, ignoring transaction costs (such as the premium paid for the call option and trading costs).

The seller of the call option is obligated to sell the shares at £6.00 per share to the call option holder, even though the market price is £7.00 per share, and thus incurs a loss of £1,000, ignoring the premium received for the call option. But if Company A’s share price is less than £6.00 per share, the call option buyer has no incentive to exercise the option; it would not make sense to voluntarily pay more than the market price. In this case, the buyer will let the option expire. Therefore, because an option buyer is not forced to exercise an option, an option’s value cannot be negative.

Alibaba Options

Now that you have an idea of what options are and how they work, we will take that idea and apply it to the real world to help in understanding the interest in Alibaba options. The interest around the largest IPO in history led to an over-subscription of the shares (investors demanded more shares than were being sold by company) and huge speculation on the price and subsequent movements in the price. So, some of the demand for options on Alibaba shares likely came from speculators who might, for example, have purchased call options in the expectation that the share price would rise.

Equally, there was also likely strong interest in options from investors who bought the underlying shares through the IPO. They might have wanted to buy put options to protect themselves against a fall in the price of the shares after the IPO. If share owners bought put options, it would give them the right to sell their shares at an agreed on price, which limits their loss in the case of volatile markets or bad news about Alibaba’s prospects.

Bottom Line

By using options, investors gain exposure to stock (or bond) markets with a fraction of the capital needed to invest directly in stocks (or bonds). In addition, the transaction costs of trading options are considerably smaller than with stocks and bonds, making them attractive to investors.