Basics of Options—Standardized Terms
Today, all listed options include standardized terms. These are the type of option (call or put), the underlying security on which options are bought or sold, the strike price, and the expiration date.
Calls and Puts
A Call Is the Right to Buy 100 Shares
A call is an intangible contract that grants its owner the right, but not the obligation, to buy 100 shares of a specific underlying stock at a fixed strike price per share and on or before a specific expiration date. The owner of the call acquires these rights in exchange for a premium paid for the option. The value of the option rises if the terms become more attractive before expiration, meaning the market price of the stock rises. If the current market value of the call is higher than the fixed strike price, the option value rises; if it remains at or below the fixed strike price, the premium value falls.
The call buyer is not obligated to exercise the option; there are three choices. The option may be allowed to expire worthless, which occurs if the current market value remains below the strike price. The contract can also be closed at a profit and sold on the open exchange. The sale might also occur at a small loss; the options trader may realize that the position is unlikely to become profitable, and taking a partial loss then becomes preferable to letting the contract expire. Finally, the options owner can exercise that option and buy 100 shares at the fixed strike price. For example, if the strike is 50 and current value per share is $56, exercise of the option enables its owner to buy 100 shares at the fixed price of $50 per share, or six dollars per share lower than current market value.
The call seller does not pay a premium, but receives one. When a trader sells an option, or goes short, the trading sequence is reversed from the sequence most people understand. Rather than the well-known long position of buy-hold-sell, a short position has the sequence sell-hold-buy. When a trader sells a call, this grants the rights under the option contract to someone else: a buyer. The seller and buyer do not meet face to face because all options trading is done through the Options Clearing Corporation (OCC), which facilitates the market (acting as seller to each buyer and as buyer to each seller). When exercise does occur, the OCC matches the transaction and assigns the shares of stock to an options writer. In the case of a short call, the seller is obligated to sell 100 shares of the underlying stock at the fixed strike price. For example, if the strike is 50 and current market value per share is $56, a seller is obligated to sell shares at the fixed strike of $50 per share, even if that means having to buy the same shares at $56 per share, or for a loss of six dollars ($600 for 100 shares).
A Put Is the Right to Sell 100 Shares
A put is the opposite of a call. This option grants its owner the right, but not the obligation, to sell 100 shares of stock at a fixed strike price, on or before a specific expiration date. Just as a call owner hopes the value of the stock will rise, a put owner hopes the value of the stock will fall. The more the price falls, the more valuable the put becomes.
A put buyer might take one of three actions before expiration. The put can be closed at its premium value and a profit or loss taken. The put can also be allowed to expire worthless, which occurs if the underlying stock is at or above the strike price at the time of expiration. Finally, the put can be exercised. This means the owner is allowed to sell 100 shares of the underlying stock at the fixed strike price. For example, if a trader owns 100 shares purchased at $50 per share and also buys a 50 put, exercise will occur at that price. If the stock’s value falls to $41 per share before expiration, the put owner can exercise the put and sell 100 shares for $50 per share, even though current market value is far lower. The put protects the stock investor from the decline by offsetting the stock loss in the appreciated value of the put.
A put seller grants the option rights to a buyer. So if a trader sells a put, it means that he might be obligated to accept 100 shares of the underlying stock at the fixed strike. If the strike is 50 and the current market value of the stock falls to $41 per share, the put will be exercised. The put seller will have 100 shares put to them at the fixed price of $50 per share, or nine points above current market value.
The Underlying Security
The underlying security in an option contract is fixed and cannot be changed. Options are traded only on a single security, which may be a stock or an index, future, currency, commodity, or exchange-traded fund (ETF). Many creative expansions and variations of the options market have been developed and continue to be introduced. Examples in this book focus on options on stock, as the best-understood and most popular form of listed options trading.
Every option refers to the rights on 100 shares of stock. A single option grants rights to those 100 shares, either to buy (call) or sell (put). The option’s current premium value is expressed on a per-share basis, however. For example, if an option is currently valued at 4.60, that means it is worth $4.60 per share, or $460.00 (per 100 shares).
The value at which options can be exercised is called the strike price (also known as striking price and exercise price). For example, if the strike is 50, it means the option will be exercised at $50 per share if and when exercise does occur. The proximity between strike price and current market value determines the option’s value, along with the amount of time remaining until expiration.
When the underlying stock’s current value is higher than a call, the call is in the money (ITM). When the price is lower than the strike, the call is out of the money (OTM). When it is exactly equal to the strike, the call is at the money (ATM).
For puts, this is opposite. When the stock’s price is higher than the put strike, it is out of the money (OTM); when the stock price is lower than the fixed strike, that put is in the money (ITM). These distinctions are very important; a strategy for buying or selling options relies on stock moving in a desired direction to create profits.
Every option is scheduled to expire in the future. The farther away the expiration date, the higher the option’s value. With options, traders coordinate time with proximity of price. The closer the strike to current market value of the underlying stock, the more the price of the option reacts to price changes in the underlying stock; the closer the expiration date, the more the option’s premium value reacts to the stock’s price movement.
When a trader opens an option, the time remaining until expiration affects the decision about which specific contract to buy or to sell. Time to expiration affects the value of the option and defines risk. For options sellers, the longer the time until expiration, the greater the risk of exercise. Exposure to this risk is one of the most important factors in comparing option prices. Exercise is most likely to occur on the last trading day, but it can occur at any time during the life of the option. For options buyers, a long time until expiration is positive because with more time, there is an increased chance of movement in the price of the underlying stock. A desirable change in value (upward for call buyers or downward for put buyers) defines whether options will be profitable or not. But a negative to this expanded time is higher cost. The more a trader pays to buy an option, the more difficult it will be to create future profits.