Stock Option Basics

Stock Option Basics

Discover how a call option and a put option work, and the difference between them.

An option is a contract to buy or sell a specific financial product; e.g., IBM stock. The specified financial product is referred to as the option's "underlying instrument," "underlying interest," or "underlying security."  The underlying instrument for equity options is a stock, exchange-traded fund (ETF), or other similar product.

Option contracts are standardized and very precise. Each contract specifies a "strike price," which is the the price at which the underlying instrument may be purchased or sold. The contracts each have an "expiration date," which is the day on which the option expires and thereafter ceases to exist.  There are only two types of options: call options and put options.

Buying and Selling Call Options & Put Options

Every option contract involves two parties, each taking the opposite side of the contract.  There is the option buyer who pays to secure the rights afforded by the option contract and there is the person who receives the money paid by the option buyer who agrees to fulfill the terms of the option contract should the option buyer later choose to exercise those rights.  An option trader can take either side of the transaction; i.e., they may be the option buyer or the option seller.

If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration.  Your risk when buying a call option or put option is limited to the price paid for the contract while the potential profit is only limited by the amount the underlying security can rise or fall in value.

The situation is different if you sell, or "write," an option option contract. Selling obligates you to fulfill your side of the contract if the holder of the option chooses to exercise their rights.

If you sell a call, you are obligated to deliver the underlying security to the call option buyer at the specified strike price. In other words, you are obligated to sell the underlying stock at the specified strike price even if the stock has moved higher in price.

If you sell a put, option you are obligated to buy the underlying security. For example, if you sell a put option on XYZ stock and the stock drops in value below the strike price, you will be obligated to buy the stock at the strike price even though it is trading in the market for a lower price.

Closing Your Option Position

Once an option position is opened, it is not necessary to hold the position until expiration.  Option buyers may sell their interest in an option contract and option sellers may terminate their obligations under an option contract by buying-to-close their short option position.

Because option contracts are standardized, it is not necessary to seek out the person who took the opposite side of your option trade when it was initially opened. An option trader simply needs to execute a closing transaction to offset their existing option position.

For example, an option buyer may simply sell their interest in an option contract by executing a "sell to close" transaction with their broker.  Just as the buyer can sell an option back into the market, an option writer can purchase an offsetting option contract and end their obligations.

American Style and European Style Options

Some options are subject to early exercise, which means that the option buyer can choose to exercise their rights to buy or sell the underlying security at any time prior to the option's expiration date.  Options subject to early exercise are referred to as American style options.

European style options are not subject to early exercise.  Generally, all stock options will be American style options while many index options are European style.  As an option seller, or an option "writer," when trading an American style option you have no control over wheher an option contract is exercised. While there are factors that significantly reduce the odds of an option being exercised, an option seller must recognize that exercise is always possible until the option expires on its expiration date.

Stock Option Premium

When you buy an option, the purchase price is called the premium. If you sell an option, you receive payment of the option's premium as a cash credit to your account.

The premium is not fixed and changes constantly.  What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there's agreement becomes the price for that transaction, and then the process begins again.

If you buy options, there is a net debit to your account. That means you've spent money you might never recover if you don't sell your option at a profit or exercise your rights under that contract.  Your risk is limited to the premium paid.

As an option seller, you receive a net credit to your account because you collect the premium paid by the option buyer. If the option is never exercised, the option will expire and you will keep the money with no further obligation to fulfill. If the option is exercised, you still get to keep the premium, but you will be obligated to buy or sell the underlying stock if you are assigned.  An option seller's profit is limited to the premium received, while risk in the trade is theoretically unlimited.

The Value of Options

What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that's determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration.

A call option is in-the-money if the current market value of the underlying stock is higher than the strike price of the option.  A call option is said to be out-of-the-money if the stock price is below the strike price of the call option.

A put option is in-the-money if the current market value of the underlying stock is lower than the strike price.  The put option would be out-of-the-money if the market price of the underlying security is higher than the put option's strike price.

At expiration, an option will be worthless unless it is in-the-money.

An option's premium has two parts: intrinsic value and extrinsic value. Intrinsic value is the amount by which the option is in-the-money. It is easily calculated by simply determining if an option is in-the-money and, if so, by how much.

Extrinsic value is often referred to as "time value" and is simply any portion of an option's price that is not explained by its intrinsic value.  The extrinsic value of an option is affected by many factors, not just the price movement of the underlying security.

Stock Options Pricing

Numerous factors effect the value of an option.  Those factors with significant impact include the price of the underlying security, the amount of time remaining before the option expires, and the overall perception of how volatile the price of the underlying security is likely to be during the life of the option contract.

The factor that has the greatest impact is unquestionably market volatility.  Professional and retail traders alike struggle to forecast the future volatility of a market, as that factor will define the value of any given option.

The problem is that no one knows what the market will do in the future, so all we can do is make our best educated guess.  The combined "guessing" within the market as to the market's future volatility drives the price of an option.

Multiple mathematical formulas have been devised to assist investors, traders, market makers, etc., when valuing option contracts.  Those formulas are all typically derived from the original Black-Scholes formula, and have been incorporated into sophisticated software applications.

While the software can be very good, all of these programs have their limits and it is still the individual trader who possesses a fundamental understanding of the factors driving an option's price that has the advantage in the market.  It is for this reason that we encourage all of our members to take the time and to make the effort to master these fundamentals.

About The Author

Christopher Smith

http://www.linkedin.com/in/theoptionclub