What is an Option?

 

An option is a contract to buy or sell a specific financial product known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange traded fund (ETF) or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon.

Contracts also have an expiration date. When an option expires, it no longer has value and no longer exists.

Options come in two varieties, calls and puts. You can buy or sell either type. You decide whether to buy or sell and choose a call or a put based on objectives as an options investor.

Buying and Selling

If you buy a call, you have the right to buy the underlying instrument at the strike price on or before expiration. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, the option holder has the right to sell the option to another buyer during its term or to let it expire worthless.

The situation is different if you write or sell to open an option. Selling to open a short option position obligates the writer to fulfill their side of the contract if the option holder wishes to exercise.

When you sell a call as an opening transaction, you're obligated to sell the underlying interest at the strike price, if assigned. When you sell a put as an opening transaction, you're obligated to buy the underlying interest, if assigned.

As a writer, you have no control over whether or not a contract is exercised, and you must recognize that exercise is possible at any time before expiration. However, just as the buyer can sell an option back into the market rather than exercising it, a writer can purchase an offsetting contract to end their obligation to meet the terms of a contract provided they have not been assigned. To offset a short option position, you would enter a buy to close transaction.

At a 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. The premium is likely to be higher or lower today than yesterday or tomorrow. Changing prices reflect the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point of agreement becomes the price for that transaction. The process then begins again.

If you buy options, you begin with 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. If you do make money on a transaction, you must subtract the cost of the premium from any income to find net profit.

As a seller, 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 keep the premium but are obligated to buy or sell the underlying stock if assigned.

The Value of Options

The worth of a particular options contract to a buyer or seller is measured by its likelihood 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. The call option is 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. A put option is out-of-the-money if its underlying price is above the exercise price. If an option is not in-the-money at expiration, the option is assumed worthless.

An option's premium can have two parts: an intrinsic value and a time value. Intrinsic value is the amount that the option is in-the-money. Time value is the difference between the intrinsic value and the premium. In general, the longer time that market conditions work to your benefit, the greater the time value.

Options Prices

Several factors affect the price of an option. Supply and demand in the market where the option is traded is a large factor. This is also the case with an individual stock.

The status of overall markets and the economy at large are broad influences. Specific influences include the identity of the underlying instrument, the instrument’s traditional behavior and current behavior. The instrument’s volatility is also an important factor used to gauge the likelihood that an option will move in-the-money.

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