Introducing Stock Options

An Overview Of Stock & Equity Options

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" or underlying interest. 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 basic types of options: Call options and Put options.   

Buying and Selling Call Options & Put Options

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.

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

If you sell a call, you're obligated to deliver the underlying interest to the call option holder at the specified strike price, if you're assigned.  In other words, you are obligated to sell the underlying stock at the specified strike price even if the stock as moved higher in price.

If you sell a put, you're obligated to buy the underlying interest, if assigned.  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.

As an option seller, or an option "writer," you have no control over whether an option contract is exercised.  You must recognize that exercise is always possible until the option expires on its expiration date.

However, just as the buyer can sell an option back into the market rather than exercising it, as a writer you can purchase an offsetting contract and end your obligation to meet the terms of the contract.

Stock Option Premium

When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn't fixed and changes constantly - so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. 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, you start out with what's known as a net debit. That means you've spent money you might never recover if you don't sell your option at a profit or exercise it. And if you do make money on a transaction, you must subtract the cost of the premium from any income you realize to find your net profit.

As a seller, on the other hand, you begin with a net credit because you collect the premium. If the option is never exercised, you keep the money. If the option is exercised, you still get to keep the premium, but are obligated to buy or sell the underlying stock if you're assigned.

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 above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless.

An option's premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the premium is. The longer the amount of time for market conditions to work to your benefit, the greater the time value.

Stock Options Pricing

Several factors, including supply and demand in the market where the option is traded, affect the price of an option, as is the case with an individual stock. What's happening in the overall investment markets and the economy at large are two of the broad influences. The identity of the underlying instrument, how it traditionally behaves, and what it is doing at the moment are more specific ones. Its volatility is also an important factor, as investors attempt to gauge how likely it is that an option will move in-the-money.

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