Introduction to Options

Options are financial instruments that provide flexibility in almost any investment situation. Options give you options by providing the ability to tailor your position to your 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 the 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 investors should know about equity options.

Describing equity options

An equity option is a contract that 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. Do not confuse the strike price, a fixed specification of an option contract, with the premium. Premium is the price at which the contract trades. This price fluctuates daily.

Equity option strike prices are listed in increments of .5, 1, 2.5, 5 or 10 points, depending on their price level.

Adjustments to an equity option contract’s size, deliverable and/or strike price may be made to account for stock splits or mergers.

Generally, at any given time, you can purchase a particular equity option with one of at least four expiration dates.

Equity option holders do not enjoy the rights due stockholders (e.g., voting rights, regular cash or special dividends). A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights.

Buyers and sellers set option prices in the exchange markets. All trading is conducted in the competitive manner of an auction market.

Calls and 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 before the option’s 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 before the option’s 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 option holder’s potential loss is limited to the initial premium paid for the contract. Alternately, the writer has an unlimited potential loss. This loss is somewhat offset by the initial premium received for the contract. For more information, visit 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 is limited to the price of the premium.

Investors can also use put and call option contracts to actively hedge against market risk. Investors can purchase a put as insurance to protect stockholding against an unfavorable market move while maintaining stock ownership.

A call option on an individual stock issue may be sold to provide a limited degree of downside protection in exchange for limited upside potential. Our Strategies Section shows various options positions and explains how options can work in different market scenarios.

Underlying security

The underlying security (such as XYZ Corporation) is the instrument that 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

Most options that expire in a given month usually expire on the third Friday of the month. Therefore, this third Friday 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.

Many products now offer short-term options with weekly expirations, so investors should know the exact contract terms, including expiration dates, for all contracts they trade.

After the option’s expiration date, the contract ceases 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 & 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 product.

Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage could 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 may face unlimited risk.

IN-THE-MONEY, AT-THE-MONEY, OUT-OF-THE-MONEY

An option’s strike price, or exercise price, determines whether a 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. This is because the holder of this call has the right to buy the stock at a price less than the price he would 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 said to be in-the-money because the holder of this put has the right to sell the stock at a price greater than the price he would receive selling the stock in the stock market.

The inverse of in-the-money is out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money.

The amount that an option, call or put is in-the-money at any time is called intrinsic value. By definition, an at-the-money or out-of-the-money option has no intrinsic value. This does not mean investors can obtain these options at no cost.

The amount that an option’s total premium exceeds intrinsic value is known as the time value. Fluctuations in volatility, interest rates, dividend amounts and the passage of time all affect the time value portion of an option’s premium. These factors give options value and therefore affect the premium at which they are traded.

Equity call options

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 options

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

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, the greater the possibility that the underlying share price might move the option in-the-money. Even if all other factors affecting an option’s price remain the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.

NOTE: Time decay is a term used to describe how the theoretical value of an option reduces with the passage of time. Time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Expiration day

The expiration date is the last day an option exists. For listed stock options, this is usually on the third Friday of the month. This is the deadline that brokerage firms must submit exercise notices to the OCC. However, the exchanges and brokerage firms have regulations and deadlines for an option holder to notify the brokerage firm of his intent to exercise. This deadline, or expiration cut off time, is generally the third Friday of the month at some time after the close of the market. Contact your brokerage firm for specific details.

The last day expiring equity options 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.

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 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 a contract that you did not own). As a result, you now have obligations from terms of that option contract. If the owner exercises the option, you must meet those obligations.

If you have sold the right to buy 100 shares of a stock, you are short a call contract. If you have sold the right to sell 100 shares of a stock, you are short a put contract.

When you write an option contract, you are creating it. The writer of an option collects and keeps the premium received from its initial sale. When you are short (write) an equity option contract:

You can be assigned an exercise notice at any time during the life of the option contract. You 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 fact that the stock cannot fall below $0 in price limits the risk of loss. This
The 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:

An opening purchase is a transaction in which the purchaser’s intention is to create or increase a long position in a given series of options.
An opening sale is a transaction in which the seller’s intention is to create or increase a short position in a given series of options.

Close

A closing purchase is a transaction in which the purchaser’s intent 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.
A closing sale is a transaction in which the seller’s intent is to reduce or eliminate a long position in a given series of options.

NOTE: An investor does not close out a long call position by purchasing a put or vice versa. A closing transaction for an option involves the purchase or sale of an option contract with the same terms on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option’s last trading day.

Exercise

The holder of an American-style option can 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. They first must direct their brokerage firm to submit an exercise notice to OCC. For an option holder to ensure that they exercise the option on that particular day, the holder must notify his brokerage firm before that day’s cut-off time for accepting exercise instructions.

The brokerage firm notifies OCC that an option holder wishes to exercise an option. OCC then randomly assigns the exercise notice to a clearing member. For an investor, this is generally his brokerage firm chosen at random from a total pool of such firms. The firm must then assign one of its customers who has written (and not covered) that particular option.

Assignment to a customer is either random or on a first-in-first-out basis. This depends on the firm’s method. Ask your brokerage firm which method it uses for assignments.

Assignment

The holder of an American-style option contract can exercise the option at any time before expiration. Therefore, an option writer may be assigned an exercise notice on a short option position at any time before expiration. If an option writer is short an option that expires in-the-money, they should expect assignment on that contract, though assignment is not guaranteed as some long in-the-money option holders may elect not to exercise in-the-money options. In fact, some option writers are assigned on short contracts when they expire exactly at-the-money or even out-of-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 is received, an investor has no alternative but to fulfill assignment obligations per the terms of the contract.

There is generally no exercise or assignment activity on options that expire out-of-the-money. Owners usually let them expire with no value. Although this is not always the case as post-market underlying moves may lead to out-of-the-money options being exercised and in-the-money options not being exercised.

What's the net?

When an investor exercises a call option, the net price paid for the underlying stock on a per share basis is 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 is 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 is 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 is 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 exercise early to own the underlying stock to receive a dividend. Check with your brokerage firm on the advisability of early call exercise.

It is extremely important to realize that assignment of exercise notices can occur early, days or weeks in advance of the expiration day. Investors should expect this as expiration nears with a call considerably in-the-money and a sizeable dividend payment approaching. Call writers should be aware of dividend dates and the possibility of early assignment.

When puts become deep in-the-money, most professional option traders exercise 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 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. It is a major factor in determining an option’s premium.

The higher the volatility of the underlying stock, the higher the premium. This is 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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Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Before trading options, please read Characteristics and Risks of Standardized Options

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