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Options are financial instruments that can provide you with
the flexibility you need in almost any investment situation
you might encounter. Options give you options by giving
you the ability to tailor your position to your own situation. |
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- You can protect stock holdings from a decline in market price.
- You can increase income against current stock holdings.
- You can prepare to buy stock at a lower price.
- You can position yourself for a big market move - even when you don't know which way prices will move.
- You can benefit from a stock price's rise or fall without incurring the cost of buying the stock outright.
The following information provides the basic terms and descriptions that any investor should know as they learn about equity options.
An equity option is a contract which conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (in the case of a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer�s request.
- Equity option contracts usually represent 100 shares of the underlying stock.
- Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. The strike price, a fixed specification of an option contract, should not be confused with the premium, the price at which the contract trades, which fluctuates daily.
- Equity option strike prices are listed in increments of 2 �, 5, or 10 points, depending on their price level.
- Adjustments to an equity option contract's size and/or strike price may be made to account for stock splits or mergers.
- Generally, at any given time a particular equity option can be bought with one of four expiration dates.
- Equity option holders do not enjoy the rights due stockholders e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights.
- Buyers and sellers in the exchange markets, where all trading is conducted in the competitive manner of an auction market, set option prices.
The two types of equity options are Calls
and Puts.
A call option gives its holder the right to buy 100 shares
of the underlying security at the strike price, anytime prior
to the options expiration date. The writer (or seller) of the
option has the obligation to sell the shares.
The opposite of a call option is a put option, which gives
its holder the right to sell 100 shares of the underlying
security at the strike price, anytime prior to the options
expiration date. The writer (or seller) of the option has the
obligation to buy the shares.
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Holder (Buyer) |
Writer (Seller) |
| Call Option |
Right to buy |
Obligation to sell |
| Put Option |
Right to sell |
Obligation to buy |
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An option's price is called the "premium". The potential loss for the holder of an option is
limited to the initial premium paid for the contract. The writer on the other hand has unlimited
potential loss that is somewhat offset by the initial premium received for the contract. For more information go to our Options Pricing section.
Investors can use put and call option contracts to take a position in a market using limited
capital. The initial investment would be limited to the price of the premium.
Investors can also use put and call option contracts to actively hedge against market risk.
A put may be purchased as insurance to protect a stock holding against an unfavorable market
move while the investor still maintains stock ownership.
A call option on an individual stock issue may be sold, providing a limited degree of downside
protection in exchange for limited upside potential. Our Strategies Section shows various options positions an investor can take and explains how options can work in different market scenarios.
The security - such as XYZ Corporation - an option writer must deliver (in the case of call) or
purchase (in the case of a put) upon assignment of an exercise notice by an option contract holder.
The Expiration day for equity options is the Saturday following the third Friday of the month.
Therefore, the third Friday of the month is the last trading day for all expiring equity
options.
This day is called "Expiration Friday". If the third Friday of the month is an exchange holiday,
the last trading day is the Thursday immediately proceeding this exchange holiday.
After the option's expiration date, the contract will cease to exist. At that point the owner of
the option who does not exercise the contract has no "right" and the seller has no "obligations"
as previously conveyed by the contract.
Options can provide leverage. This means an option buyer can pay a relatively small
premium for market exposure in relation to the contract value (usually 100 shares of
the underlying stock). An investor can see large percentage gains from comparatively
small, favorable percentage moves in the underlying index. Leverage also has downside
implications. If the underlying stock price does not rise or fall as anticipated during the
lifetime of the option, leverage can magnify the investment�s percentage loss. Options
offer their owners a predetermined, set risk. However, if the owner�s options expire with no
value, this loss can be the entire amount of the premium paid for the option. An uncovered
option writer, on the other hand, may face unlimited risk.
The strike price, or exercise price, of an option determines whether that contract is in-the-
money , at-the-money, or out-of-the-money. If the strike price of a call option is less than
the current market price of the underlying security, the call is said to be in-the-money because
the holder of this call has the right to buy the stock at a price which is less than the price he
would have to pay to buy the stock in the stock market. Likewise, if a put option has a strike
price that is greater than the current market price of the underlying security, it is also said to
be in-the-money because the holder of this put has the right to sell the stock at a price which
is greater than the price he would receive selling the stock in the stock market. The converse
of in-the-money is, not surprisingly, out-of-the-money. If the strike price equals the current
market price, the option is said to be at-the-money.
The amount by which an option, call or put, is in-the-money at any given moment is called its
intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic
value; the time value is the total option premium. This does not mean, however, these options
can be obtained at no cost. Any amount by which an option�s total premium exceeds intrinsic
value is called the time value portion of the premium. It is the time value portion of an option�s
premium that is affected by fluctuations in volatility, interest rates, dividend amounts, and the
passage of time. There are other factors that give options value and therefore affect the premium
at which they are traded. Together, all of these factors determine time value.
| In-the-money = strike price less than stock price |
| At-the-money = strike price same as stock price |
| Out-of-the-money = strike price greater than stock price |
| In-the-money = strike price greater than stock price |
| At-the-money = strike price same as stock price |
| Out-of-the-money = strike price less than stock price |
| Intrinsic Value + Time Value |
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Generally, the longer the time remaining until an option�s expiration, the higher its premium will be.
This is because the longer an option�s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option�s price remaining the same, the time value portion of an option�s premium will decrease (or decay) with the passage of time.
Note: This time decay increases rapidly in the last several weeks of an option's life. When an option expires in-the-money, it is generally only worth its intrinsic value.
The expiration date is the last day an option exists. For listed stock options, this is the
Saturday following the third Friday of the expiration month. Please note that this is the deadline
by which brokerage firms must submit exercise notices to OCC; however, the exchanges and
brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally
on the third Friday of the month, before expiration Saturday, at some time after the close of the
market. Please contact your brokerage firm for specific deadlines. The last day expiring equity
options generally trade is also on the third Friday of the month, before expiration Saturday. If that
Friday is an exchange holiday, the last trading day will be one day earlier, Thursday.
With respect to this section's usage of the word, long describes a position (in stock
and/or options) in which you have purchased and own that security in your brokerage
account. For example, if you have purchased the right to buy 100 shares of a stock,
and are holding that right in your account, you are long a call contract. If you have
purchased the right to sell 100 shares of a stock, and are holding that right in your
brokerage account, you are long a put contract. If you have purchased 1,000 shares
of stock and are holding that stock in your brokerage account, or elsewhere, you are
long 1,000 shares of stock.
When you are long an equity option contract:
- You have the right to exercise that option at any time prior to its expiration.
- Your potential loss is limited to the amount you paid for the option contract.
With respect to this section's usage of the word, short describes a position in options in which
you have written a contract (sold one that you did not own). In return, you now have the obligations inherent in the terms of that option contract. If the owner exercises the option, you have an
obligation to meet. If you have sold the right to buy 100 shares of a stock to someone else, you
are short a call contract. If you have sold the right to sell 100 shares of a stock to someone else,
you are short a put contract. When you write an option contract you are, in a sense, creating it.
The writer of an option collects and keeps the premium received from its initial sale.
When you are short (i.e., the writer of) an equity option contract:
- You can be assigned an exercise notice
at any time during the life of the option contract. All option writers should be aware that assignment prior to expiration is a distinct possibility.
- Your potential loss on a short call is theoretically
unlimited. For a put, the risk of loss is limited by
the fact that the stock cannot fall below zero in
price. Although technically limited, this potential
loss could still be quite large if the underlying
stock declines significantly in price.
An opening transaction is one that adds to, or creates a new trading position. It can be either
a purchase or a sale. With respect to an option transaction, consider both:
- Opening purchase — a transaction in which the
purchaser�s intention is to create or increase a
long position in a given series of options.
- Opening sale — a transaction in which the
seller�s intention is to create or increase a
short position in a given series of options.
- Closing purchase — a transaction in which the purchaser�s intention is to reduce or eliminate a short position in a given series of options.
This transaction is frequently referred to as "covering" a short position.
- Closing sale — a transaction in which the seller�s intention is to reduce or eliminate a long position in a given series of options.
If the holder of an American-style option decides to exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock, the holder must direct his brokerage firm to submit an exercise notice to OCC. In order to ensure that an option is exercised on a particular day other than expiration, the holder must notify his brokerage firm before its exercise cut-off time for accepting exercise instructions on that day.
Once OCC has been notified that an option holder wishes to exercise an option, it will assign the exercise notice to a clearing member - for an investor, this is generally his brokerage firm - with a customer who has written (and not covered) an option contract with the same terms. OCC will choose the firm to notify at random from the total pool of such firms. When an exercise is assigned to a firm, the firm must then assign one of its customers who has written (and not covered) that particular option. Assignment to a customer will be made either randomly or on a �first in first out� basis, depending on the method used by that firm. You can find out from your brokerage firm which method it uses for assignments.
The holder of a long American-style option contract can exercise the option at any time until the option expires. It follows that an option writer may be assigned an exercise notice on a short option position at any time until that option expires. If an option writer is short an option that expires in-the-money, assignment on that contract should be expected, call or put. In fact, some option writers are assigned on such short contracts when they expire exactly at-the-money. This occurrence is usually not predictable.
To avoid assignment on a written option contract on a given day, the position must be closed out before that day�s market close. Once assignment has been received, an investor has absolutely no alternative but to fulfill his obligations from the assignment per the terms of the contract. An option writer cannot designate a day when assignments are preferable. There is generally no exercise or assignment activity on options that expire out-of-the-money. Owners generally let them expire with no value.
When an investor exercises a call option, the net price paid for the underlying stock on a per share basis will be the sum of the call�s strike price plus the premium paid for the call. Likewise, when an investor who has written a call contract is assigned an exercise notice on that call, the net price received on per share basis will be the sum of the call�s strike price plus the premium received from the call�s initial sale.
When an investor exercises a put option, the net price received for the underlying stock on per share basis will be the sum of the put�s strike price less the premium paid for the put. Likewise, when an investor who has written a put contract is assigned an exercise notice on that put, the net price paid for the underlying stock on per share basis will be the sum of the put�s strike price less the premium received from the put�s initial sale.
For call contracts, owners might make an early exercise in order to take possession of the underlying stock in order to receive a dividend.Check with your brokerage firm on the advisability of such an early call exercise. It is therefore extremely important to realize that assignment of exercise notices can occur early - days or weeks in advance of expiration day. As expiration nears, with a call considerably in-the-money and a sizeable dividend payment approaching, this can be expected. Call writers should be aware of dividend dates, and the possibility of an early assignment.
When puts become deep in-the-money, most professional option traders will exercise them before expiration. Therefore, investors with short positions in deep in-the-money puts should be prepared for the possibility of early assignment on these contracts.
Volatility is the tendency of the underlying security�s market price to fluctuate either up or down. It reflects a price change�s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option�s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an underlying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.
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