What is an Option? - Part 2

 

Leverage & Risk

Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying product.

Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage could magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer may face unlimited risk.

In-the-money, At-the-money, Out-of-the-money

An option’s strike price, or exercise price, determines whether a 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. This is because the holder of this call has the right to buy the stock at a price less than the price he would pay to buy the stock in the stock market. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is said to be in-the-money because the holder of this put has the right to sell the stock at a price greater than the price he would receive selling the stock in the stock market.

The inverse of in-the-money is out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money.

The amount that an option, call or put is in-the-money at any time is called intrinsic value. By definition, an at-the-money or out-of-the-money option has no intrinsic value. This does not mean investors can obtain these options at no cost.

The amount that an option's total premium exceeds intrinsic value is known as the time value. Fluctuations in volatility, interest rates, dividend amounts and the passage of time all affect the time value portion of an option’s premium. These factors give options value and therefore affect the premium at which they are traded.

Equity Call Option

  • In-the-money = strike price less than stock price
  • At-the-money = strike price same as stock price
  • Out-of-the-money = strike price greater than stock price

Equity Put Option

  • In-the-money = strike price greater than stock price
  • At-the-money = strike price same as stock price
  • Out-of-the-money = strike price less than stock price

Option Premium

  • Intrinsic Value + Time Value

Time Decay

NOTE: Time decay is a term used to describe how the theoretical value of an option reduces with the passage of time. Time decay increases rapidly in the last several weeks of an option's life. When an option expires in-the-money, it is generally worth only its intrinsic value.

The longer the time remaining until an option's expiration, the higher its premium will be. This is because the longer an option's lifetime, the greater the possibility that the underlying share price might move the option in-the-money. Even if all other factors affecting an option's price remain the same, the time value portion of an option's premium will decrease (or decay) with the passage of time.

Expiration Day

The expiration date is the last day an option exists. For listed stock options, this is the Saturday following the third Friday of the expiration month. This is the deadline that brokerage firms must submit exercise notices to OCC. However, the exchanges and brokerage firms have regulations and deadlines for an option holder to notify the brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally on the third Friday of the month, before expiration Saturday, at some time after the close of the market. Contact your brokerage firm for specific deadlines.

The last day expiring equity options trade is also on the third Friday of the month, before expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day earlier.

Long

With respect to this section's usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account.

For example, if you have purchased the right to buy 100 shares of a stock and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock and are holding that right in your brokerage account, you are long a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account or elsewhere, you are long 1,000 shares of stock.

When you are long an equity option contract:

  • You have the right to exercise that option at any time prior to expiration.
  • Your potential loss is limited to the amount you paid for the option contract.

Short

With respect to this section's usage of the word, short describes a position in options in which you have written a contract (sold a contract that you did not own). As a result, you now have obligations from terms of that option contract. If the owner exercises the option, you must meet those obligations.

If you have sold the right to buy 100 shares of a stock, you are short a call contract. If you have sold the right to sell 100 shares of a stock, you are short a put contract.

When you write an option contract, you are creating it. The writer of an option collects and keeps the premium received from its initial sale. When you are short (write) an equity option contract:

  • You can be assigned an exercise notice at any time during the life of the option contract. You should be aware that assignment prior to expiration is a distinct possibility.
  • Your potential loss on a short call is theoretically unlimited. For a put, the fact that the stock cannot fall below $0 in price limits the risk of loss. This potential loss could still be quite large if the underlying stock declines significantly in price.

Open

An opening transaction is one that adds to or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, consider both:

  • An opening purchase is a transaction in which the purchaser's intention is to create or increase a long position in a given series of options.
  • An opening sale is a transaction in which the seller's intention is to create or increase a short position in a given series of options.

Close

NOTE: An investor does not close out a long call position by purchasing a put or vice versa. A closing transaction for an option involves the purchase or sale of an option contract with the same terms on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option's last trading day.
  • A closing purchase is a transaction in which the purchaser's intent is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as covering a short position.
  • A closing sale is a transaction in which the seller's intent is to reduce or eliminate a long position in a given series of options.

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