by Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell depending on the type of contract they hold the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
- Call options allow the holder to buy the asset at a stated price within a specific timeframe.
- Put options allow the holder to sell the asset at a stated price within a specific timeframe.
Any formal agreement between two parties, option contracts clearly delineate all of the parameters of the contract between buyer and seller.
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Underlying stock
Option contracts are an agreement to either buy or sell 100 shares of stock. We need to specify which stock we are trading through the option contract. In our example, “XYZ” is the stock symbol that we are trading. “XYZ” could be any stock that has option contracts – Apple, Facebook, Boeing – just to name a few. The underlying stock price is one of the key inputs into the option pricing model, so this is a key piece of information when trading options.
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Date of expiration
Option contracts have a finite life. The expiration date tells us when the option contract will expire. In our example, “February” represents the time of expiration. Monthly options expire on the third Friday of the month: a “February” expiration option like this one will expire on the third Friday in February.
It is important to note that there are also weekly expiration dates. Weekly expiration options expire on Friday of that week. At Option Posts, however, we prefer to stick with monthly expiration contracts because weekly contracts tend to be less liquid, which is an important factor that we consider.
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Strike price
The third option contract specification is the strike price. Option contracts are an agreement to either buy or sell stock at a certain price in the future. This is a different number from the current stock price. The strike price specifies the price at which the stock transaction will take place, even if the stock price is currently trading at a different price. In our example, the strike price is 50. This means that the option buyer and the option seller agree to transact stock at a price of $50 per share should the option buyer choose to “exercise,” or use, the contract, even if the stock is trading at a different value, say $48, at the time the contract is made.
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Call vs put
Next, we must specify whether it is a call contract or a put contract. This indicates whether the option buyer wants to buy stock with a call contract, or sell stock with a put contract. In our example, it is a “call” contract, meaning the option buyer has the right but not the obligation to buy 100 shares of stock at the strike price at any point in the future up until the expiration date.
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Credit or debit price
Lastly, we have to indicate the price or premium paid for the option contract. This is the price that the option buyer and option seller agree upon to initiate the option contract.
Explanation about Options
Options are a versatile financial product. These contracts involve a buyer and a seller, where the buyer pays an options premium for the rights granted by the contract. Each call option has a bullish buyer and a bearish seller, while put options have a bearish buyer and a bullish seller.
Options contracts usually represent 100 shares of the underlying security, and the buyer will pay a premium fee for each contract. For example, if an option has a premium of 35 cents per contract, buying one option would cost $35 ($0.35 x 100 = $35). The premium is partially based on the strike price the price for buying or selling the security until the expiration date. Another factor in the premium price is the expiration date. Just like with that carton of milk in the refrigerator, the expiration date indicates the day the option contract must be used. The underlying asset will determine the use-by date. For stocks, it is usually the third Friday of the contract’s month.
Traders and investors will buy and sell options for several reasons. Options speculation allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Investors will use options to hedge or reduce the risk exposure of their portfolio. In some cases, the option holder can generate income when they buy call options or become an options writer. Options are also one of the most direct ways to invest in oil. For options traders, an option’s daily trading volume and open interest are the two key numbers to watch in order to make the most well-informed investment decisions.
American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.
Options Trading Terminology
Call Option
A call option gives the buyer the right to buy 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a call option is obligated to sell the stock at the strike price if the option is exercised.
Put Option
A put option gives the buyer the right to sell 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a put option is obligated to purchase the stock at the strike price if exercised.
Strike (or Exercise) Price
The strike price is the price per share at which the holder can purchase (for call options) or sell (for put options) the underlying stock.
Exercise
Exercise is the process by which an option buyer (holder) invokes the terms of the option contract. If exercising, calls will buy the underlying stock, while put owners will sell the underlying stock under the terms set by the option contract. All option contracts that are in-the-money (i.e. have at least one cent of intrinsic value) at expiration will be automatically exercised.
Expiration Date
The expiration date is the last day on which the option may be exercised. Monthly listed stock options cease trading on the third Friday of each month and expire the next day. Weekly options cease trading on Friday of that week.
Hedging
Hedging is a conservative strategy used to reduce investment risk by implementing a transaction that offsets an existing position.
Covered Call
A covered call is a call option that is written (sold) against an existing stock position. The call is said to be “covered” by the underlying stock, which could be delivered if the call option is exercised.
Intrinsic Value
The intrinsic value of an option is the amount of profit that can be theoretically obtained if the option is exercised at that moment and the stock either purchased (for calls) or sold (for puts) at the current market price. If an option has positive intrinsic value, it is said to be “in-the-money” (ITM) and if it has negative intrinsic value it is said to be “out-of-the-money” (OTM). For instance an XYZ January 25 Call would have $1.50 of intrinsic value if the stock were trading at $26.50, regardless of its market price at the time.
Time Value
Time value is the amount by which an option’s market price exceeds its intrinsic value. In the case above with the XYZ January 25 Call priced at $3.00 while XYZ stock is trading at $26.50, the intrinsic value is $1.50 and the remaining $1.50 is time value. If an option is out-of-the-money (i.e. has no intrinsic value) then the entire market price is considered time value.
Premium
The price of an option is called its premium. Prices are quoted per share, but premium is usually the entire dollar value of the contract (price per share X 100 shares = total premium).
Time Decay
Because options have an expiration date, all options are wasting assets whose time value erodes to zero by expiration. This erosion is known as time decay. Time value varies with the square root of time, so that as an option approaches its expiration date, the rate of time decay increases.
Long
To be “long” an option simply means to have purchased it in an opening transaction and thus to own or hold it.
Short
To be short an option means to have sold the option in an opening transaction. (A short position is carried as a negative on a statement and must be purchased later to close out.)
LEAPS (Long-term Equity AnticiPation Securities)
These are long-term options with expiration dates as far out as three years, usually expiring in January.
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