Chooser Option: What it Means, How it Works, Example

What Is a Chooser Option?

A chooser option is an option contract that allows the holder to decide whether it is to be a call or put prior to the expiration date. Chooser options usually have the same strike price and expiration date regardless of what decision the holder makes.

Because the option could benefit from upside or downside movement, chooser options provide investors a great deal of flexibility and thus may cost more than comparable vanilla options.

Understanding Chooser Options

Chooser options are a type of exotic option. These options are generally traded on alternative exchanges without the support of regulatory regimes common to vanilla options. As such, they can have higher risks of counterparty default.

Chooser options offer the holder the flexibility to choose between a put or a call. These options are typically constructed as a European option with a single expiration date and strike price. The holder has the right to exercise the option only on the expiration date.

A chooser option can be a very attractive instrument when an underlying security sees an increase in volatility, or when a trader is unsure whether the underlying will rise or fall in value. For example, an investor may select a chooser option on a biotech company awaiting the Food and Drug Administration’s approval (or non-approval) of its drug.

That said, chooser options tend to be more expensive than European vanilla options, and high implied volatility will increase the premium paid for the chooser option. Therefore, a trader must weigh the cost of the option against their potential payoff, just like with any option.

Special Considerations

Payoffs for chooser options follow the same basic methodology used in analyzing a vanilla call or put option. The difference is that the investor has the option to choose the specified payoff they desire at expiration based on whether the call or put position is more profitable.

If an underlying security is trading above its strike price at expiration then the call option is exercised. If the holder chooses to exercise the option as a call option then the payoff is underlying price - strike price - premium. In this scenario, the holder benefits from buying the security at a lower price than it is selling for in the market.

If a security is trading below its strike price at expiration, then the put option is exercised. If the holder chooses to exercise their option as a put option then the payoff is strike price – underlying price - premium. In this scenario, the holder benefits from selling the underlying security at a higher price than it is trading for in the open market.

It is important to note, however, that the typical decision time to choose is midway between the transaction date and expiration date. The closer the decision date is to the expiration date, the more expensive the option price is.

Example of a Chooser Option on a Stock

Assume a trader wants to have an option position for the updating Bank of America Corporation (BAC) earnings release. They think the stock will have a big move, but they are not sure in which direction.

The earnings release is in one month, so the trader decides to buy a chooser option that will expire about three weeks after the earnings release. They believe this should provide enough time for the stock to make a significant move if it is going to make one, and fully digest the earnings release. Therefore, the option they choose will expire in seven to eight weeks.

The chooser option allows them to exercise the option as a call if the price of BAC rises, or as a put if the price falls.

At the time of the chooser option purchase, BAC is trading at $28. The trader chooses an at-the-money strike price of $28 and pays a premium of $2 or $200 for one contract ($2 x 100 shares).

The buyer can't exercise the option prior to expiry since it is a European option. At expiry, the trader will determine if they will exercise the option as a call or put.

Assume the price of BAC at the time of expiry is $31. This is higher than the strike price of $28, therefore the trader will exercise the option as a call. Their profit is $1 ($31 - $28 - $2) or $100.

If BAC is trading between $28 and $29.99 the trader will still choose to exercise the option as a call, but they will still be losing money since the profit is not enough to offset their $2 cost. $30 is the breakeven point on the call.

If the price of BAC is below $28, the trader will exercise the option as a put. In this case, $26 is the breakeven point ($28 - $2). If the underlying is trading between $28 and $26.01 the trader will lose money since the price didn't fall enough to offset the cost of the option.

If the price of BAC falls below $26, say to $24, the trader will make money on the put. Their profit is $2 ($28 - $24 - $2) or $200.

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