Chooser OptionUrvi Surti
An option contract that allows the holder to decide the nature of the option i.e., whether the option is a call or put before the expiry date is called a Chooser Option. It is an option contract where the holder may choose at some point during the life of the option whether the option is a call or a put. These options have the same strike price and expiry date regardless of it being a call or a put.
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How does it work?
Also known as the AC-DC option, a chooser option is an investment option where the investor has the ability to exercise the option as a put or call at specific points during the life of the option. Depending on the direction of underlying movement, the option is defined to set up easy profits. The decision is made before expiration. However, once the call or put is selected, it cannot be changed back. The more volatile the underlying, the more expensive the option is. Either call or put will have the same strike and expiration, the only uncertainty is in the direction of movement. The decision to pick one or the other also should be picked with exercise in mind like does a trader expect a profit from the exercise of a call or a put. Exercise form is in European style, meaning early exercise is not allowed.
Assuming that Ms. Mary a trader wants to have an option position for the updating earnings release of CITI Bank. She thinks that the stock will have a big move, but she is unsure of the direction. The earnings release in a fortnight, so she decides to buy a chooser option that will expire about four weeks after the earnings release. She believes that this will give enough time to the stock to make a significant move if it is going to make one, and fully digest the earnings release. Therefore, the option she chose will expire in seven to eight weeks.
The chooser option allows her to exercise the option as a call if the price of CITI Bank rises, or as a put in alternate conditions.
At the time of the chooser option purchase, CITI Bank is trading at $50 so Mary chooses an ATM strike price of $50 and pays a premium of $3 or $300 for one contract ($3 x 100 shares).
Mary cannot exercise the option prior to the expiration date since it is a European option. At expiry, she will determine if she will exercise the option as a call or put.
Assume the price of CITI Bank at the time of expiry is $54 which is higher than the strike price of $50, therefore she will exercise the option as a call. Her profit is $1 ($54 – $50 – $3) or $100.
If CITI Bank is trading between $50 and $52.99 Mary will still choose to exercise the option as a call, but she will still be losing money since the profit is not enough to offset their $3 cost. $53 is the BEP on the call.
If the price of CITI Bank is below $50, Mary will exercise the option as a put. In this case, $47 is the breakeven point ($50 – $3). If the underlying is trading between $50 and $47.01 Mary will lose money since the price didn’t fall enough to offset the cost of the option.
If the price of CITI Bank falls below $47, say to $44, Mary will make money on the put. Her profit is $3($50 – $44 – $3) or $300.
Advantages and Drawbacks
- The stock option holder has the right to decide whether the option is a call or a put.
- The options are cheaper than straddles, hence deciding the nature of the options becomes easy.
- A directional view is not required in chooser options.
- The only disadvantage is that the chooser option is expensive than a simple call or a put.
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A chooser option gives the holder the flexibility to decide whether the option will be a call or put. They are typically constructed as European Options with the same expiry and strike price. Generally, they are traded on alternative exchanges without the support of regulatory regimes.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).