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This web site discusses options education information only. No statement in this web site is to be construed as a recommendation to purchase or sell a security, or to provide investment advice. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL 60606 (1- 800-678-4667)
An option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.
Option Contract Specifications
The following terms are specified in an option contract.
The two types of stock options are puts and calls. Call options confers the buyer the right to buythe underlying stock while put options give him the rights to sell them.
The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It's relation to the market value of the underlying asset affects the moneyness of the option and is a major determinant of the option's premium.
In exchange for the rights conferred by the option, the option buyer have to pay the option seller a premium for carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration.
Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified for each option contract. The specific date on which expiration occurs depends on the type of option. For instance, stock options listed in the United States expire on the third Friday of the expiration month.
An option contract can be either american style or european style. The manner in which options can be exercised also depends on the style of the option. American style options can be exercised anytime before expiration while european style options can only be exercise on expiration date itself. All of the stock options currently traded in the marketplaces are american-style options.
The underlying asset is the security which the option seller has the obligation to deliver to or purchase from the option holder in the event the option is exercised. In the case of stock options, the underlying asset refers to the shares of a specific company. Options are also available for other types of securities such as currencies, indices and commodities.
The contract multiplier states the quantity of the underlying asset that needs to be delivered in the event the option is exercised. For stock options, each contract covers 100 shares.
The Options Market
Participants in the options market buy and sell call and put options. Those who buy options are called holders. Sellers of options are called writers. Option holders are said to have long positions, and writers are said to have short positions.Type your paragraph here.
A call option is an option contract in which the holder (buyer) has the right (but not the obligation)to buy a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Buying Call Options
Call buying is the simplest way of trading call options. Novice traders often start off trading options by buying calls, not only because of its simplicity but also due to the large ROI generated from successful trades.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares.
Say you were spot on and the price of XYZ stock rallies to $50 after the company reported strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, your call buying strategy will net you a profit of $800.
Let us take a look at how we obtain this figure.
If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000.
Since you had paid $200 to purchase the call option, your net profit for the entire trade is $800. It is also interesting to note that in this scenario, the call buying strategy's ROI of 400% is very much higher than the 25% ROI achieved if you were to purchase the stock itself.
This strategy of trading call options is known as the long call strategy. See our long call strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.
Selling Call Options
Instead of purchasing call options, one can also sell (write) them for a profit. Call option writers, also known as sellers, sell call options with the hope that they expire worthless so that they can pocket the premiums. Selling calls, or short call, involves more risk but can also be very profitable when done properly. One can sell covered calls or naked (uncovered) calls.
The short call is covered if the call option writer owns the obligated quantity of the underlying security. The covered call is a popular option strategy that enables the stockowner to generate additional income from their stock holdings thru periodic selling of call options. See our covered call strategy article for more details.
Naked (Uncovered) Calls
When the option trader write calls without owning the obligated holding of the underlying security, he is shorting the calls naked. Naked short selling of calls is a highly risky option strategy and is not recommended for the novice trader. See our naked call article to learn more about this strategy.
A call spread is an options strategy in which equal number of call option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Call spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time.
A put option is an option contract in which the holder (buyer) has the right (but not the obligation)to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).
For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.
For stock options, each contract covers 100 shares.
Buying Put Options
Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.
A Simplified Example
Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.
Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.
Let's take a look at how we obtain this figure.
If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don't own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.
This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formula for calculating maximum profit, maximum loss and break even points.
Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.
Selling Put Options
Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.
The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.
The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.
For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.
A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time.
The strike price is defined as the price at which theholder of an options can buy (in the case of a call option) or sell (in the case of a put option) theunderlying security when the option isexercised. Hence, strike price is also known as exercise price.
Strike Price, Option Premium & Moneyness
When selecting options to buy or sell, for options expiring on the same month, the option's price (aka premium) and moneyness depends on the option's strike price.
Relationship between Strike Price & Call Option Price
For call options, the higher the strike price, the cheaper the option. The following table lists option premiums typical for near term call options at various strike prices when the underlying stock is trading at $50
Strike Price Moneyness Call Option Premium Intrinsic Value Time Value
35 ITM $15.50 $15 $0.50
40 ITM $11.25 $10 $1.25
45 ITM $7 $5 $2
50 ATM $4.50 $0 $4.50
55 OTM $2.50 $0 $2.50
60 OTM $1.50 $0 $1.50
65 OTM $0.75 $0 $0.75
Relationship between Strike Price & Put Option Price
Conversely, for put options, the higher the strike price, the more expensive the option. The following table lists option premiums typical for near term put options at various strike prices when the underlying stock is trading at $50
Strike Price Moneyness Put Option Premium Intrinsic Value Time Value
35 OTM $0.75 $0 $0.75
40 OTM $1.50 $0 $1.50
45 OTM $2.50 $0 $2.50
50 ATM $4.50 $0 $4.50
55 ITM $7 $5 $2
60 ITM $11.25 $10 $1.25
65 ITM $15.50 $15 $0.50
Strike Price Intervals
The strike price intervals vary depending on the market price and asset type of the underlying. For lower priced stocks (usually $25 or less), intervals are at 2.5 points. Higher priced stocks have strike price intervals of 5 point (or 10 points for very expensive stocks priced at $200 or more). Index options typically have strike price intervals of 5 or 10 points while futures options generally have strike intervals of around one or two points.
The price paid to acquire the option. Also known simply as option price. Not to be confused with thestrike price. Market price, volatility and time remaining are the primary forces determining the premium. There are two components to the options premium and they are intrinsic value and time value.
The intrinsic value is determined by the difference between the current trading price and the strike price. Only in-the-money options have intrinsic value. Intrinsic value can be computed for in-the-money options by taking the difference between the strike price and the current trading price. Out-of-the-money options have no intrinsic value.
An option's time value is dependent upon the length of time remaining to exercise the option, themoneyness of the option, as well as the volatility of the underlying security's market price.
The time value of an option decreases as its expiration date approaches and becomes worthless after that date. This phenomenon is known as time decay. As such, options are also wasting assets.
For in-the-money options, time value can be calculated by subtracting the intrinsic value from the option price. Time value decreases as the option goes deeper into the money. For out-of-the-money options, since there is zero intrinsic value, time value = option price.
Typically, higher volatility give rise to higher time value. In general, time value increases as the uncertainty of the option's value at expiry increases.
Effect of Dividends on Time Value
Time value of call options on high cash dividend stocks can get discounted while similarly, time value of put options can get inflated.
Moneyness is a term describing the relationship between the strike price of an option and the current trading price of its underlying security. In options trading, terms such as in-the-money, out-of-the-money and at-the-money describe the moneyness of options.
A call option is in-the-money when its strike price is below the current trading price of the underlying asset.
A put option is in-the-money when its strike price is above the current trading price of the underlying asset.
In-the-money options are generally more expensive as their premiums consist of significantintrinsic value on top of their time value.
Calls are out-of-the-money when their strike price is above the market price of the underlying asset.
Puts are out-of-the-money when their strike price is below the market price of the underlying asset.
Out-of-the-money options have zero intrinsic value. Their entire premium is composed of only time value. Out-of-the-money options are cheaper than in-the-money options as they possess greater likelihood of expiring worthless.
An at-the-money option is a call or put option that has a strike price that is equal to the market price of the underlying asset. Like OTM options, ATM options possess no intrinsic value and contain only time value which is greatly influenced by the volatility of the underlying security and the passage of time.
Often, it is not easy to find an option with a strike price that is exactly equal to the market price of the underlying. Hence, close-to-the-money or near-the-money options are bought or sold instead.
All options have a limited useful lifespan and every option contract is defined by an expiration month. The option expiration date is the date on which an options contract becomes invalid and the right toexercise it no longer exists.
When do Options Expire?
For all stock options listed in the United States, the expiration date falls on the third Friday of the expiration month (except when that Friday is also a holiday, in which case it will be brought forward by one day to Thursday).
Stock options can belong to one of three expiration cycles. In the first cycle, the JAJO cycle, the expiration months are the first month of each quarter - January, April, July, October. The second cycle, the FMAN cycle, consists of expiration months Febuary, May, August and November. The expiration months for the third cycle, the MJSD cycle, are March, June, September and December.
At any given time, a minimum of four different expiration months are available for every optionable stock. When stock options first started trading in 1973, the only expiration months available are the months in the expiration cycle assigned to the particular stock.
Later on, as options trading became more popular, this system was modified to cater to investors' demand to use options for shorter term hedging. The modified system ensures that two near-month expiration months will always be available for trading. The next two expiration months further out will still depend on the expiration cycle that was assigned to the stock.
Determining the Expiration Cycle
As there is no set pattern as to which expiration cycle a particular optionable stock is assigned to, the only way to find out is to deduce from the expiration months that are currently available for trading. To do that, just look at the third available expiration month and see which cycle it belongs to. If the third expiration month happens to be January, then use the fourth expiration month to check.
This information is provided by theoptionsguide.com