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The Basics: What Is an Option?

Summary

Options are used for speculation, income generation, or hedging a position.

Options buyers pay a premium for the right to, but not the obligation, to act.

Options sellers (writers) have an obligation (if assigned).

There are four basic positions: buying calls, buying puts, selling calls, selling puts.

Option premiums are made up of intrinsic value and time value.

Time value is largely a function of implied volatility.

Trading stocks is reasonably easy, at least in theory. If you think a stock is going up, buy it. If you think it is going down, sell it; or sell it short if you are a real risk-taker. If you think a stock is going nowhere, sell it or avoid it in the first place. The stock price is what it is and that is what you pay. Things are not so simple with options trading. Many factors influence the value of an option contract. It is for largely that reason that most retail options traders underestimate the challenge of making money with options.

Would you like to...

  • Increase your leverage without paying margin rates?
  • Profit from dropping prices - with limited risk?
  • Generate more income in your account?
  • Get paid to enter long stock positions?
  • Insure your positions or even your whole portfolio?

Options are exceptionally versatile. You can do all of the above with the use of options.

What is an Option?

An option is a standardized contract providing for the right - but not the obligation - to buy or sell an underlying financial instrument. In our context, this underlying is a stock or exchange traded fund (ETF). The contract controls 100 shares, and is good until a defined expiration date. The price at which shares can be bought or sold also is defined by the contract, and is known as the strike price.

There are two types of options: calls and puts. You can buy or sell either type. If you buy an option you are the holder of the contract and considered to be "long," while if you sell an option you are the "writer" of the contract and considered to be "short."

The buyer of a call has the right to buy the underlying security (e.g. 100 shares of Google) at the strike price on or before the expiration date. The seller of a call has the obligation to sell the shares, if asked.

The buyer of a put has the right to sell the underlying security (e.g. 100 shares of Google) at the strike price on or before the expiration date. The seller of a put has the obligation to buy the shares, if asked.

Holder
(Buyer)
Writer
(Seller)
Call OptionRight to buyObligation to sell
Put OptionRight to sellObligation to buy

Option Price and Value

Premium

In exchange for the right to buy ("call") or sell ("put") an underlying security on or before the expiration date, the purchaser of an option pays a premium. The price of the contract is known as the debit, and it is the purchaser's maximum risk. On the other side of the trade, the seller of the option receives the premium as a credit to his/her brokerage account, but is obligated to buy (in the case of a short put) or sell (in the instance of a short call) the underlying shares if the purchaser exercises the contract. Brokerages hold cash from the premium as a guarantee against short positions.

The strike price, or exercise price, of an option determines whether that 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 because the holder of the call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the market. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in the money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive in the market. The converse of in the money is, not surprisingly, out of the money. If the strike price equals the current market price, the option is said to be at the money.

CallPut
In the money (ITM)Strike price < Stock priceStrike price > Stock price
At the money (ATM)Strike price = Stock priceStrike price = Stock price
Out of the money (OTM)Strike price > Stock priceStrike price < Stock price

Intrinsic Value and Time Value

The premium of an option has two components, intrinsic value and time value.

Intrinsic value describes the amount the stock price is above the strike price (for calls), or below the strike price (for puts). Therefore the amount by which an option is in the money is intrinsic value. It is also the value of the contract at expiration.

Time value is defined as the option premium minus the intrinsic value. It is the amount that you pay for the possibility that it will be worth more in the future. Therefore an at-the money or out-of-the-money option has no intrinsic value and only time value.

CallsPuts
Intrinsic Value = Stock Price - Strike PriceIntrinsic Value = Strike Price - Stock Price
Time Value = Option Price - Intrinsic ValueTime Value = Option Price - Intrinsic Value

Intrinsic value is only affected by moves in the underlying security.

Time value is subject to several factors, primarily time to expiration and implied volatility. Implied volatility is the market's expectation of the future volatility of the underlying stock. It is derived from the option price itself, and represents demand for the option. The higher the implied volatility, the more expectation that the underlying stock will make big moves, increasing the option's chances of being in the money. This also means that the option's premiums (that is, its time value) are higher. However, the value of time decays as expiration nears: time decay increases dramatically in the last 30 days as expiration approaches.

Option Price as Time Passes

Let's consider an example using Google (GOOG). If GOOG were trading at $500 when you bought a 490 strike call option for $25, then $10 of the option's value would be intrinsic value.

The other $15 would be time value. A 500 call purchased when GOOG is trading for 500 is at the money, but is all time value. It has no intrinsic value.

If the stock were at 500 when you bought a 510 call, the option is again all time value, since it has to rise $10 to be in the money.

Stock Price = $500Strike Price
490 call = $25500 call = $18510 call = $10
In-the-moneyAt-the-moneyOut-of-the-money
$10 Intrinsic$0 Intrinsic$0 Intrinsic
$15 time value$18 time value$10 time value

Buying Calls

You want leverage? Buying calls gives you leverage over 100 shares of an underlying stock (or ETF) at the strike price until the expiration date. Long calls are used to profit from upward moves in the underlying.

Again using Google for an example, the GOOG December 500 call option gives you the right to buy 100 shares of GOOG for $500 per share up until the expiration date in December. You would do this with the expectation that the price of the option will rise, usually through the rise in the price of the underlying stock.

Let's say you purchased the GOOG 500 call option for $25 when the stock was trading for $500. If GOOG goes up to $550 before expiration, then your call is worth at least $50. This gives you a 100 percent return on the call option based on a 10 percent return on the stock. That is the leverage of buying options.

Long call example

The flip side is that if the stock does not move up, then the option will lose all of its value by expiration. This results from the decay of the value of the option's premium, known as time decay. That is the risk of buying calls. Since they are expiring assets, they have time value that diminishes over time. But regardless of how far the stock falls, your risk is limited to the cost of the call.

GOOGStock P/L% ReturnCall P/L% Return
$200($300)-60%($25)-100%
$50000%($25)-100%
$550$5010%$25100%
$600$10020%$75300%

Exiting Long Calls

When a call has been purchased, the position can be closed in one of three ways:

  • Selling the call - Once an option is bought it can be sold at any time. This is the most common way of exiting a long position, and the only way of exiting a long call that captures any remaining time value in the option.
  • Letting it expire - If a call gets all the way to expiration, it will expire worthless if it is out-of the money (when the strike price is above the stock price). If the stock price is above the strike price by $.01 or more, it will be automatically exercised and shares will be delivered to your brokerage account. Long calls are almost always sold before expiring, since at that point they will have lost all time value.
  • Exercising your call - Utilizing the "right to buy" that is inherent in the call contract is known as "exercising" the option. This results in your brokerage delivering shares of the stock to you at the strike price. Options are rarely bought with the intention of exercising the underlying right. Taking this course also forgoes any remaining time value in the option.

Buying Puts

Want to profit from the downside? Puts give the buyer the right to sell a specific number of shares (usually 100) of an underlying stock at the strike price until the expiration date. Long puts will profit if the underlying price falls, all else held equal. Buying puts therefore offers a limited-risk way to profit from the downside. This also makes them a way to protect positions as insurance (see the lesson on Protective Puts).

Long put example

In this case, let's say you were concerned about the downside, so you purchased the GOOG 500 put option for $25 when GOOG the stock was trading for $500. If GOOG goes down to $450 before expiration, then your put is worth at least $50. This gives you a 100 percent return on the put option with a 10 percent loss on the stock.

GOOGStock P/L% ReturnPut P/L% Return
$400($100)-20%$75300%
$450($50)-10%$25100%
$50000%($25)-100%
$600$10020%($25)-100%

Buying puts on a stock you own can provide insurance on that position. Index puts can also be used to insure your entire portfolio. Buying puts is very much like buying insurance: you pick the deductable and the premiums.

Exiting Long Puts

When a put has been purchased, the position can be closed in one of three ways:

  • Selling the put - Once a put is bought it can be sold at any time, and this is the most common way of exiting a long position. This is the only way of exiting a long position that captures any remaining time value in the option.
  • Letting it expire - If a put gets all the way to expiration, it will expire, worthless if it is out of the money (when the stock price is above the strike price - See Options Pricing). If the stock price is below the strike price by $.01 or more, it will be automatically exercised and shares will be "taken" from your brokerage account. Long options are almost always sold before expiring, as at that point they will have lost all time value.
  • Exercising the option - Utilizing the "right to sell" that is inherent in the put contract is known as exercising the option. This delivers shares of the stock from your account at the strike price. Options are rarely bought with the intention of exercising the underlying right. Taking this course also forgoes any remaining time value in the option.

Rules for Buying

Regardless of whether you are buying calls or puts, there are some general rules to follow. One, the expiration should give the option enough time to perform without being overexposed to time decay. Since options have an expiration date, a large part of their value is time value (for more, see our lesson on Options Pricing). This time value will deteriorate as that expiration approaches; time decay increases exponentially in the last 30 to 45 days of an options life, so this is usually not the time to own options.

Two, options should generally be bought when the time value - primarily influenced by a factor known as implied volatility, or the expected price swings of the underlying - is expected to stay flat or to rise. Buying options is a limited-risk strategy, and all of that risk lies in the premium paid for the option. All else equal, if there is a rise in implied volatility, then there will be a rise in the option premiums. This increase can produce profits for long options, even if the stock price doesn't move, because the chance of movement has increased. Conversely, if you buy options when implied volatility and premiums are high, such as before earnings, then the stock can move in the direction that you want and you can still lose money, because with the news out, the implied volatility could fall.

Finally, when you buy an option, generally you will want to sell it, ideally for a still-greater premium. You do not want it to expire, since you will receive zero premium, and normally you don't want to exercise your right to purchase the underlying shares, unless that is your particular strategy (say for tax reasons). In both of these cases, you lose whatever time value is left in the option. So with future resale value in mind, we can see why risk management rules are important, such as taking profits when your position doubles or closing out the position when it loses half of their entry value.

Selling Calls

Interested in generating income? When option premiums are high (that is, when implied volatility is high), some traders turn to selling options. Selling "naked" calls, so called because you do not own the underlying shares as a hedge in case you are assigned, is a neutral to bearish strategy. You want the market price to be below the strike of the call you sold, so that it expires worthless. Selling calls should be done when you expect the underlying stock to fall or stay flat.

Option buyers have rights, but option sellers have obligations. By selling calls, you are obligating yourself to selling the stock at the strike price when you are assigned. Assignment is the other side of an option being exercised. If a call buyer decides to exercise the long call, that exercise is put out randomly to a seller -any seller - of that call, and the individual is obligated to sell stock to the call buyer.

If you do not own the shares of the stock when assigned, then you will have to come up with them. This is the reason that brokerages require a margin account for individuals who wish to sell naked calls. It is also the reason that selling calls is considered the options strategy with the highest risk. Stocks can go up infinitely, and so the risk of a naked call is unlimited. Naked calls are the strategy that gives options a bad name among the risk averse.

By way of explanation, let's say you sold the GOOG 500 call option for $25 when GOOG was trading for $500. If GOOG is anywhere below 500 at expiration, then you keep your credit of $25. If the stock goes up to $525, however, you will be assigned at expiration, but will come out flat since you already pocketed a credit of $25. As the stock price continues upward, your losses mount.

GOOGStock P/L% ReturnCall P/L
$300($200)-40%$25
$50000%$25
$550$5010%($25)
$700$20040%($175)

Because of this unlimited risk as the underlying stock price rises, selling calls is rarely done in isolation. In fact, selling calls against stock that you own, known as "covered calls" or "buy-writes," is considered the most conservative options strategy. (For more, see the lesson on Covered Calls.)

Selling Puts

Want to be paid to buy stock? Many stock investors use "limit orders" to get into long positions. Another way to buy stock for less than the current market price is an options strategy called cash-secured puts. Cash secured means that you have the cash in your account to buy the stock at the designated strike price. Selling puts is usually done with options that have high implied volatility. This is a neutral to bullish strategy which can be used to generate income, or to enter long stock positions.

Selling puts obligates you to buy the stock when assigned. This strategy brings income into your account, income you keep if the stock is above the strike price at expiration. Traders sell puts if they think the stock is going to stay flat or go up slightly, but only if they are willing to buy the stock if assigned. For this reason, selling puts can be an excellent way to initiate long stock positions, and get paid to do so.

Let's say you sold the GOOG 500 put option for $25 when the stock was trading for $500. If GOOG is anywhere above 500 at expiration, then you keep your credit of $25. If the stock is below, you will be assigned, and you will purchase the stock at the strike price. But the trade itself is profitable until $475, since you pocketed the $25 credit.

Short put example
GOOGStock P/L% ReturnPut P/L
$300($200)-40%($175)
$4500 0%($25)
$500$5010%$25
$700$20040%$25

Puts can be sold cash-secured or naked. If they are cash secured, then you have the cash in your account to purchase the stock at the strike price if assigned. If naked, then a lower margin is required. This would increase the return on margin, but also increase the potential risk.

Exiting Short Positions

When an option has been sold, the position can be closed in one of three ways:

  • Buying back the option - After an option is sold, it can be bought back at any time. This is done when there is a risk of assignment that the option seller wants to avoid. For instance, if you sold a call, the stock went up through your strike, and you do not want to be assigned and forced to sell the stock, you could buy back the option to close the position.
  • Letting it expire -If the option gets all the way to expiration, it will expire, worthless if it is out of the money. Typically, this is what you want to have happen with options that you have sold. If it is in the money by $.01, it will be automatically exercised and you will be assigned, automatically selling stock if you were short a call or buying stock if you were short a put.
  • Assignment - American-style options (all equity and ETF options) can be exercised at any time before expiration. So you could be assigned at any time after you have sold an option. Most traders view this as a negative, but it is not necessarily so. If you are using cash-secured puts to acquire stock, then assignment means you have achieved your objective at a below-market price.

Rules for Selling

Selling options is best done when implied volatilities, and therefore option premiums, are high and expected to fall. This is because higher implied volatility brings in more premium income to your account. It is important to remember, however, that selling options involves considerable risk, and high implied volatility can always go higher.

Since we already know that time decay is greatest in the last 30 to 45 days, this is typically the best time to sell options. Here we the ideal is to have the options expire worthless, and we are not interested in buying back the options we have sold unless necessary.

Review of Basic Strategies with Examples

Profit from stock price gains with limited risk and lower cost than buying the stock outright
Example: You buy one Intel (INTC) 25 call with the stock at 25, and you pay $1. INTC moves up to $28 and so your option gains at least $2 in value, giving you a 200% gain versus a 12% increase in the stock.
Profit from stock price drops with limited risk and lower cost than shorting the stock
Example: You buy one Oracle (ORCL) 20 put with ORCL at 21, and you pay $.80. ORCL drops to 18 and you have a gain of $1.20, which is 150%. The stock lost 10%.
Profit from sideways markets by selling options and generating income
Example: You own 100 shares of General Electric (GE). With the stock at 34, you sell one 35 call for $1.00. If the stock is still at 34 at expiration, the option will expire worthless, and you made a 3% return on your holdings in a flat market.
Get paid to buy stock
Example: Apple (AAPL) is trading for 175, a price you like, and you sell an at-the-money put for $9. If the stock is below 175 at expiration, you are assigned, and essentially purchase the shares for $166.
Protect positions or portfolios
Example: You own 100 shares of AAPL at 190 and want to protect your position, so you buy a 175 put for $1. Should the stock drop to 120, you are protected dollar for dollar from 174 down, and your loss is only $16, not $70.

Option Terminology

Calls
The right, but not the obligation, to buy a specific number of shares of the underlying security at a defined price, until the expiration date.
Puts
The right, but not the obligation, to sell a specific number of shares of the underlying security at a defined price until the expiration date.
Strike price
The price at which option holders can exercise their rights.
Exercise
The process in which the buyer of an option takes, or makes, delivery of the underlying contract.
Assignment
The process by which the seller of an option is notified that the contract has been exercised.
Expiration
The time at which an option can no longer be exercised.
In the Money (ITM)
A call (put) option whose strike price is below (above) the stock price.
At the Money (ATM)
An option whose strike price is roughly equal to the stock price.
Out of the Money (OTM)
A call (put) option whose strike price is above (below) the stock price.
American style
An option that can be exercised at any time before expiration
European style
An option that can be exercised only at expiration. (Note: These are mainly index securities.)
Intrinsic value
The amount that an option is in the money.
Time value
The price of an option less the intrinsic value.

Option Chains

For any given option contract, we need to know the most recent prices and other factors. Option chains show data for a given underlying's different strike prices and expiration months.

Options chain example
  • At the top, we have the stock information and then different expiration months. In this case we are looking at Intel (INTC) April 08.
  • Down the middle are the strike prices. Calls are on the left, puts on the right.
  • Contracts in the money are yellow, and out of the money are white.
  • Each strike lists:
    • The price of the last trade ("Last")
    • The price at which there are willing buyers (the "Bid")
    • The price at which a contract is offered for sale (the "Ask" or "Offer")
    • The volume of the day's trading ("Vol")
    • The contract's "open interest" ("Open Int"), which tells us how many active contracts there are for a given month and strike.

High open interest figures, generally near the at-the-money strikes, tell us there are more prospective trading partners who could accept your price. But note that volume does not equal open interest, since some trades are made to close positions.


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Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options. Copies may be obtained from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606 or call 1-888-OPTIONS or visit www.888options.com.

This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OptionMonster Holdings. OptionMonster Holdings does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs.

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