What are chooser options?
A chooser option is an option contract that allows the holder to decide whether to call or put before the expiration date. Chooser options usually have the same strike price and expiration date, regardless of the decision made by the holder.
Tusor options offer great flexibility to investors and therefore can be more costly than comparable vanilla options, as options can benefit from upward or downward movements.
- The chooser option allows the buyer to decide whether to exercise the option as a call or as a put.
- Due to its flexibility, the chooser option is more expensive than the equivalent vanilla option.
- Chooser options are usually European style and have one strike price and one expiration date, regardless of whether the option is exercised as a call or put.
Understand selector options
Selector options are a type of exotic option. These options are typically traded on alternative exchanges without the support of the regulatory system common to vanilla options. Therefore, the risk of counterparty defaults can be high.
The selector option gives the holder the flexibility to choose between put and call. These options are usually built as European options with a single expiration date and strike price. The holder reserves the right to exercise the option only on the maturity date.
If the underlying security sees an increase in volatility, or if the trader does not know whether the underlying asset will increase or decrease in value, the chooser option will be a very attractive tool. For example, an investor can choose a selection option for a biotechnology company awaiting approval (or disapproval) of a drug by the Food and Drug Administration.
That said, tuner options tend to be more expensive than European vanilla options, and high implied volatility increases the premium paid for tuner options. Therefore, traders, like any other option, should weigh the cost of the option against the potential payoff.
The chooser option payoff follows the same basic method used to analyze vanilla calls or put options. The difference is that investors can choose the specific payoff they want at maturity based on whether the call or put position is more profitable.
If the underlying security is traded above the strike price at maturity, the call option will be exercised.If the holder chooses to exercise the option as a call option, the reward is Underlying Asset Price-Exercise Price-Premium.. In this scenario, the holder profits by buying the security at a lower price than is sold on the market.
If the security is trading below the strike price at maturity, the put option will be exercised.If the holder chooses to exercise the option as a put option, the reward is Strike Price-Underlying Asset Price-Premium.. In this scenario, the holder profits by selling the underlying security at a higher price than is traded on the open market.
Example of stock tuner options
Suppose a trader wants an optional position to update their earnings release at Bank of America Corporation (BAC). They think stocks will make a big move, but they don’t know which direction they are in.
Since the revenue release is less than a month, traders have decided to purchase a chooser option that expires approximately three weeks after the revenue release. They believe that if the stock intends to do that, it should provide enough time to make a significant move and completely digest the release of earnings. Therefore, the options they choose will expire in 7-8 weeks.
The chooser option allows you to exercise the option as a call if the BAC price rises and as a put if the price falls.
BAC is trading at $ 28 at the time of purchase of the chooser option. Traders choose an exercise price of $ 28 and pay a premium of $ 2 or $ 200 per contract ($ 2 x 100 shares).
As a European option, buyers cannot exercise the option before maturity. At maturity, the trader decides whether to exercise the option as a call or put.
Suppose the BAC price at expiration is $ 31. This is higher than the strike price of $ 28, so traders exercise the option as a call. Their profit is $ 1 ($ 31- $ 28- $ 2) or $ 100.
If the BAC is trading between $ 28 and $ 29.99, the trader still chooses to exercise the option as a call, but the trader still chooses because the profit is not enough to offset the cost of $ 2. Lose money $ 30 is the break-even point for calls.
If the BAC price is less than $ 28, the trader will exercise the option as a put. In this case, $ 26 is the break-even point ($ 28- $ 2). If the underlying asset is trading between $ 28 and $ 26.01, the trader loses money because the price did not fall enough to offset the cost of the option.
If the price of BAC falls below $ 26, for example $ 24, traders will make money with putto. Their profit is $ 2 ($ 28- $ 24- $ 2) or $ 200.