What are Chooser options?
A chooser option is a special type of option contract in finance. It lets the person who buys it pick between a call option and a put option. The call and put options have the same strike price and expiration date.
What makes a chooser option special
Chooser options are different from regular options in a key way. With a normal option, you have to decide if you want a call or a put when you first buy it. But with a chooser option, you can wait and choose later on. This gives you more flexibility.
How chooser options work
Let’s say a company’s stock is trading at $100 per share. You think the price might go up or down a lot in the next 3 months. So you buy a 3-month chooser option with a strike price of $100.
This means anytime in the next 3 months, you can choose:
- A call option with a $100 strike price
- A put option with a $100 strike price
Both options will expire in 3 months no matter when you pick.
If the stock goes up to $120, you’d want to choose the call option. You could exercise it and buy shares for $100, then sell them for $120. You’d make a $20 per share profit.
If the stock drops to $80 instead, you’d pick the put option. You could buy shares for $80 and exercise the put to sell them for $100. Again, you’d make $20 per share.
The flexibility of chooser options
The big advantage of chooser options is you don’t have to predict if the stock will go up or down. You can wait and see what happens, then choose the type of option that will be profitable.
This is different from a straddle, where you buy both a call and a put at the start. With a chooser option, you only end up with one or the other.
The cost of chooser options
Of course, this flexibility isn’t free. Chooser options are more expensive than regular options.
This is because they give you two chances to profit rather than one. The option seller is taking on more risk, so they charge a higher premium.
When to use chooser options
Chooser options are most useful when you expect a big move in a stock’s price, but aren’t sure which direction it will go.
For example, say a company is awaiting a major court ruling that could send its stock sharply higher or lower. A chooser option would let you profit from a big move in either direction.
The risks of chooser options
While chooser options provide flexibility, they also have risks. The main one is you pay a high premium for an option that could end up worthless.
If the stock stays around $100, neither the call nor the put will have any value at expiration. You’ll lose the entire premium you paid, which is higher than you’d pay for a regular call or put.
Chooser options and option pricing
Pricing chooser options is complicated. It depends on factors like the stock price, strike price, time to expiration, interest rates, dividends, and volatility.
Pricing models have to account for the fact the buyer can choose the most profitable option. This makes them more complex than models for standard options.
Chooser options in the real world
Chooser options are a bit of an exotic instrument. They’re not as widely traded as standard calls and puts.
However, they can be useful for sophisticated traders who want to profit from market volatility. They’re sometimes used by hedge funds and institutional investors.
Alternatives to chooser options
If you’re bullish on a stock, you might just buy a call option. If you’re bearish, you’d buy a put.
If you think the stock will make a big move but aren’t sure which way, a long straddle (buying both a call and put) is an alternative to a chooser option.
Regulation of chooser options
Chooser options, like other derivatives, are regulated by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
Brokers have to be licensed to sell them, and there are rules about disclosing risks to investors. However, they’re not as tightly regulated as stocks or bonds.
Taxation of chooser options
Profits and losses from chooser options are treated as capital gains or losses for tax purposes.
If you hold the option for more than a year before exercising or selling it, you’d qualify for the lower long-term capital gains tax rate. Less than a year would be short-term capital gains taxed as ordinary income.
Chooser options and risk management
Chooser options can be used to manage risk in a portfolio. For example, say you own a stock and are worried about a short-term price drop. You could buy a chooser option as a hedge.
If the stock does fall, you could exercise the put option to sell your shares at a higher price. This would offset some of your losses. If the stock rises instead, you’d choose the call option which would expire worthless. But you’d still profit from the increase in your stock’s value.
Of course, this hedging strategy comes at a cost – the premium you pay for the chooser option. And it only protects you for the term of the option contract.
