What is Chooser Option?
Consider you have a barrel of wheat that you want to sell three months from now, but you fear that the prices might fall in the future. To hedge this risk, you get into a contract with a potential buyer that they will buy your wheat barrel three months later at a pre-determined price of X. Now, you are at a profit if the prices go below X and the buyer would only agree to your proposed price if they speculate the prices to go above it.
These two off-setting positions or expectations explained above are a form of derivatives trading in an organized market. A derivatives is a contract whose value is derived from a pre-specified asset or an underlying. These assets can be stocks, Bonds, commodities, or currencies. In other words, derivatives are secondary security that derives their value from primary security.
A derivatives contract that allows you to transact securities at a specific date and price is known as the Options contract and can be of various types. This article details what the chooser option is.
An option contract that allows the holder to select whether it would be a call or a put option before the maturity date is known as the chooser option. A call option gives the holder a right to buy whereas a put option gives the holder a right to sell the underlying security at a specified price, called the strike price. The strike price of a chooser option remains the same irrespective of the holder’s choice of option.
The advantage of a chooser option is that it provides flexibility to the investors. This flexibility comes at a higher cost than a comparable regular options contract.
It is at the contract holder’s discretion if the option shall be exercised as either a call or a put. The nomenclature of this type of options contract implies the meaning of a chooser option. Typically, chooser options have one exercise price and one expiration date, irrespective of the option being exercised as a call or a put. The decision that how the contract would expire is taken before the maturity date, during the contract period.
Due to its complexity and expensiveness, a chooser option is considered an exotic option. It has the potential to benefit the contract buyer from both the upside and the downside movement and is hence more expensive than a single options contract.
How does a Chooser Option Work?
The Chooser Option is a great fit for volatile assets when the investor is unsure about the direction the asset would move in. In such cases, an investor can opt for a chooser option.
If the underlying asset is above its strike price, the contract shall be executed as a call option. In this case, the trader earns a payoff by buying the security at a lower price. But, if the underlying asset's price is below its strike price, then the put option gets exercised. Here, the option holder benefits from selling the underlying at a higher price than dealing with it in the market.
Profit of the chooser option if expired as a call option = Underlying price - Strike price – Premium
Profit of the chooser option if expired as a put option = Strike price - Underlying price – Premium
For instance, you anticipate Bharti Airtel’s share price will be impacted drastically after the 5G spectrum auction. But, you are unsure if it would be a positive or a negative impact. So you decide to buy a chooser option, one month before the 5G spectrum auction. The maturity date of this contract is three weeks after the auction. You believe three weeks to be an appropriate time for the stock price to absorb the auction news.
The chooser option allows them to exercise the call option if the price of Bharti Airtel rises, or as a put option if the price falls.
Advantages and Disadvantages of the Chooser Option
Exotic options like the chooser options have more upside than the downside.
Advantages of the chooser option include:
- You get to choose if the contract would be a call option or a put option.
- A clear directional view is not required while purchasing the chooser option.
Disadvantages of the chooser option include:
- It is expensive compared to a pre-defined options contract.
- It is often traded on an OTC platform rather than a regulated exchange and thus poses some default risk.
Frequently Asked Questions Expand All
Ans: An options contract where the contract holder can decide if the execution would be like a call or a put is known as the chooser option.
Ans: A clear directional view of the underlying security is not required while purchasing a chooser option. The option holder can decide at a certain point during the tenure if it should be executed as the call option or a put option.
Ans: Payoff of the chooser option, if executed as a call option is calculated as the underlying price - strike price. If the option matures as a put option, the payoff will be calculated as the strike price - the underlying price.
Ans: Payoff refers to the amount the investor receives after the execution whereas profit refers to the net amount investors gain after subtracting the option buying price or the premium.