What Is a Chooser Option?
A chooser option is a option contract that permits the holder to conclude whether it is to be a call or put prior to the expiration date. Chooser options normally have the equivalent strike price and expiration date paying little heed to what decision the holder makes.
Since the option could benefit from upside or downside movement, chooser options give investors a great deal of flexibility and in this manner might cost more than comparable vanilla options.
Figuring out Chooser Options
Chooser options are a type of exotic option. These options are generally traded on alternative exchanges without the support of regulatory systems common to vanilla options. In that capacity, they can have higher risks of counterparty default.
Chooser options offer the holder the flexibility to pick either a put or a call. These options are typically built as a European option with a single expiration date and strike price. The holder has the privilege to exercise the option just on the expiration date.
A chooser option can be an exceptionally alluring instrument when an underlying security sees an increase in volatility, or when a trader is uncertain whether the underlying will rise or fall in value. For instance, an investor might choose a chooser option on a biotech company anticipating the Food and Drug Administration's endorsement (or non-endorsement) of its medication.
All things considered, chooser options will more often than not be more costly than European vanilla options, and high implied volatility will increase the premium paid for the chooser option. Subsequently, a trader must gauge the cost of the option against their possible payoff, just like with any option.
Payoffs for chooser options follow a similar fundamental methodology utilized in dissecting a vanilla call or put option. The difference is that the investor has the option to pick the predefined payoff they want at expiration in view of whether the call or put position is more profitable.
Assuming that an underlying security is trading over its strike price at expiration then the call option is exercised. In the event that the holder decides to exercise the option as a call option, the payoff is underlying price - strike price - premium. In this scenario, the holder benefits from buying the security at a lower price than it is selling for in the market.
On the off chance that a security is trading below its strike price at expiration, the put option is exercised. In the event that the holder decides to exercise their option as a put option, the payoff is strike price - underlying price - premium. In this scenario, the holder benefits from selling the underlying security at a higher price than it is trading for in the open market.
It is important to note, nonetheless, that the regular decision time to pick is halfway between the transaction date and expiration date. The nearer the decision date is to the expiration date, the more costly the option price is.
Illustration of a Chooser Option on a Stock
Expect a trader needs to have an option position for the refreshing Bank of America Corporation (BAC) earnings release. They think the stock will have a big move, yet they are don't know in which bearing.
The earnings release is in one month, so the trader chooses to buy a chooser option that will terminate around three weeks after the earnings release. They accept this ought to give sufficient opportunity to the stock to take a huge action on the off chance that it will make one, and completely digest the earnings release. Accordingly, the option they pick will terminate in seven to about two months.
The chooser option permits them to exercise the option as a call in the event that the price of BAC rises, or as a put assuming the price falls.
At the hour of the chooser option purchase, BAC is trading at $28. The trader picks a at-the-money strike price of $28 and pays a premium of $2 or $200 for one contract ($2 x 100 shares).
The buyer can't exercise the option prior to expiry since it is an European option. At expiry, the trader will decide whether they will exercise the option as a call or put.
Accept the price of BAC at the hour of expiry is $31. This is higher than the strike price of $28, thusly the trader will exercise the option as a call. Their profit is $1 ($31 - $28 - $2) or $100.
In the event that BAC is trading somewhere in the range of $28 and $29.99 the trader will in any case decide to exercise the option as a call, yet they will in any case be losing money since the profit isn't sufficient to offset their $2 cost. $30 is the breakeven point on the call.
On the off chance that the price of BAC is below $28, the trader will exercise the option as a put. In this case, $26 is the breakeven point ($28 - $2). In the event that the underlying is trading somewhere in the range of $28 and $26.01 the trader will lose money since the price didn't fall to the point of offsetting the cost of the option.
In the event that the price of BAC falls below $26, say to $24, the trader will bring in money on the put. Their profit is $2 ($28 - $24 - $2) or $200.
- Due to its greater flexibility, a chooser option will be more costly than a comparable vanilla option.
- Chooser options are typically European style and have one strike price and one expiration date whether or not the option is exercised as a call or put.
- A chooser option allows the buyer to choose if the option will be exercised as either a call or put.