Chooser Option (Finance) - Explained
What is a Chooser Option?
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Table of ContentsWhat is a Chooser Option?How Does a Chooser Option Work?Example of a Chooser Option Advantages of the chooser optionChooser Option DrawbackThe Bottom Line
What is a Chooser Option?
A chooser option in finance refers to a contract that offers the holder a chance to decide whether to take a put or call option. This is usually done ahead of the expiration date. A call option refers to a contract that allows an investor to buy stocks at a price already pre-determined. This buyer usually gets profits when the invested assets price increases. A put option, on the other hand, is an agreement that allows the owner of a bond to sell it at a set price within a certain period of time. Chooser options have a set expiration date and striker price regardless of the option the owner of the stock takes.
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How Does a Chooser Option Work?
Note that during the expiration date, there are two ways the option can go. If the asset is above its strike price, then the call option goes automatically. Here, the traders will benefit by buying the asset at a low price, instead of trading it. But, if the asset is below its strike price, then, they will exercise the put option. Here, the owners will get profits if they decide to sell the bond at a high price than dealing with it in the market. The main factor that determines the price of a chooser option is the assets liability to change rapidly. If the unpredictability of the asset is high, then the price of the chooser option will be expensive. The best market for this option is the clients. They expect unpredictable change on an asset. Nonetheless, they cannot exactly tell which direction the change will take.
Example of a Chooser Option
For example, lets assume that the Bank of America Corporation is updating its earnings release in one month. And, the trader wants to have an option to choose depending on the direction it will take. The trader then decides to buy a chooser option which will expire in three weeks after the release. So, this chooser option allows the trader to choose a call option if the pricing of the release rises, or a put option if the prices fall. Note that, a chooser option can be applied in almost every market situation. However, it may require the trader to have a keener eye in order to choose between the two options. The time of making a choice also has to be put into consideration. This is because it also affects the price of a chooser option. A chooser option is suitable for traders who anticipate strong volatility, but they are unsure of the direction to go. Chooser option, therefore, becomes an appropriate mechanism as far as taking a position on volatility is concerned. In other words, the chooser option provides traders with the flexibility to make a choice that will benefit them.
Advantages of the chooser option
Chooser option has several advantages to investors. They include the following:
- The owner of the stock/bond has the option to decide whether it is a call or put.
- This option is cheaper compared to a straddle, which allows the owner to choose the call or put options simultaneously.
- With chooser option, there is no need for a directional view.
Chooser Option Drawback
Chooser option has one major drawback. It happens to be more expensive compared to a single call or put.
The Bottom Line
In todays market, many financial instruments have been introduced. This has brought complications in the market, and investors have to face this dilemma every day. This complexity issue has many exotic options in the market, which people have continued to misunderstand. Current studies have mostly focused on developing other models for pricing options. They have also described more clearly how they can be used in the market.