What is an Option? - Part 1
Options are financial instruments that provide flexibility in almost any investment situation. Options give you options by providing the ability to tailor your position to your situation.
- You can protect stock holdings from a decline in market price.
- You can increase income against current stock holdings.
- You can prepare to buy stock at a lower price.
- You can position yourself for a big market move, even when you don't know which way prices will move.
- You can benefit from a stock price's rise or fall without incurring the cost of buying the stock outright.
The following information provides the basic terms and descriptions that investors should know about equity options.
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Describing Equity Options
- An equity option is a contract that conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (in the case of a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer's request.
- Equity option contracts usually represent 100 shares of the underlying stock.
- Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. Do not confuse the strike price, a fixed specification of an option contract, with the premium. Premium is the price at which the contract trades. This price fluctuates daily.
- Equity option strike prices are listed in increments of .5, 1, 2.5, 5 or 10 points, depending on their price level.
- Adjustments to an equity option contract's size, deliverable and/or strike price may be made to account for stock splits or mergers.
- Generally, at any given time, you can purchase a particular equity option with one of at least four expiration dates.
- Equity option holders do not enjoy the rights due stockholders (e.g., voting rights, regular cash or special dividends). A call holder must exercise the option and take ownership of underlying shares to be eligible for these rights.
- Buyers and sellers set option prices in the exchange markets. All trading is conducted in the competitive manner of an auction market.
Calls and Puts
The two types of equity options are calls and puts.
A call option gives its holder the right to buy 100 shares of the underlying security at the strike price, anytime before the option's expiration date. The writer (or seller) of the option has the obligation to sell the shares.
The opposite of a call option is a put option, which gives its holder the right to sell 100 shares of the underlying security at the strike price, anytime before the option's expiration date. The writer (or seller) of the option has the obligation to buy the shares.
|Holder (Buyer)||Writer (Seller)|
|Call Option||Right to buy||Obligation to sell|
|Put Option||Right to sell||Obligation to buy|
The Options Premium
An option's price is called the premium. The option holder’s potential loss is limited to the initial premium paid for the contract. Alternately, the writer has unlimited potential loss. This loss is somewhat offset by the initial premium received for the contract. For more information, visit our Options Pricing section.
Investors can use put and call option contracts to take a position in a market using limited capital. The initial investment is limited to the price of the premium.
Investors can also use put and call option contracts to actively hedge against market risk. Investors can purchase a put as insurance to protect a stock holding against an unfavorable market move while maintaining stock ownership.
A call option on an individual stock issue may be sold to provide a limited degree of downside protection in exchange for limited upside potential. Our Strategies Section shows various options positions and explains how options can work in different market scenarios.
The underlying security (such as XYZ Corporation) is the instrument that an option writer must deliver (in the case of call) or purchase (in the case of a put) upon assignment of an exercise notice by an option contract holder.
Most options that expire in a given month usually expire on the third Friday of the month. Therefore, this third Friday is the last trading day for all expiring equity options.
This day is called Expiration Friday. If the third Friday of the month is an exchange holiday, the last trading day is the Thursday immediately preceding this exchange holiday.
Many products now offer short-term options with weekly expirations, so investors should know the exact contract terms, including expiration dates, for all contracts they trade.
After the option's expiration date, the contract ceases to exist. At that point, the owner of the option who does not exercise the contract has no right and the seller has no obligations as previously conveyed by the contract.
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