Education Resource

What is an Option?

Posted at January 13, 2016 » By : » Categories : Education Resource » 0 Comment

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Introduction

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.

  • 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.

Describing 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 1, 2.5, 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.

Calls & Puts

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.

 

The Options Premium

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.

Underlying Security

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.

Expiration Friday

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 preceding 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.

Leverage and Risk

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.

In-the-Money, At-the-Money, Out-of-the-Money

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.

 

 

 Equity call option:
 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
 Equity put option:
 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
 Option Premium:
 Intrinsic Value + Time Value

Time Decay

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.

Expiration Day

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.

Long

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.

Short

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.


Open

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.

Close

  • 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.

Exercise

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.

Assignment

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.

What’s the Net?

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.

Early Exercise/ Assignment

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

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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