The Fundamentals of Stock Options

What are options?

Firstly, there are two types of options. You have call options and you have

In both cases of put and call options, the holder of the option is also known as the buyer of the option. The call or put option gives the holder(buyer) the right but not the obligation to buy or sell  the underlying security at a specified price on or before a specified date.

Buyers have rights & Sellers have obligations

So why isn’t the buyer of the option obligated to buy or sell shares of the underlying security? Well, since they have bought the option, it is their prerogative as to whether they should exercise that option, that is, the right to buy or sell 100 shares of the underlying security.

You have to remember that there are 2 sides to every market. The options market functions like any other market in the world. To facilitate, liquidity, these rules have been put in place to avoid confusion in the first place.

What about the seller of the options contract?

So we have mentioned that owners of the options have the right but not the obligation to exercise the option. In the case of the seller of the option contract however, they are obliged to buy or sell 100 shares for every contract that they have sold. The seller of an options contract is also called the writer of the contract.

Standardised contract specifications

All of the pertinent information in an option is packaged into a standardised contract. These standardised contracts contain information such as the expiration date of the contract, the number of shares underlying the contract and the  strike or exercise price.

Usually, an option contract has an underlying stock of 100 shares if it is not otherwise stated. That means that an option contract represents 100 shares of a certain stock in simple terms.

So if one were to buy a call options contract, he effectively gains exposure to 100 shares at a fraction of the original cost that he would have to pay to buy 100 shares.

An options contract has several specifications

  • Option type
  • Exercise price
  • Premium
  • Expiration date
  • The underlying security
  • Option style
  • Contract multiplier

What is a call options contract?

A call options contract gives the holder, also known as the buyer the right to buy 100 shares of an underlying security at a specified price, on or before the expiration date as stated in the contract. After the expiration date, the options ceases to exist.

What is a put options contract?

A put options contract is a contract that gives the holder, also known as the buyer(owner) of the contract the right but not the obligation to sell 100 shares of an underlying security at a specified price, on or before the expiration date as stated in the contract. After the expiration date, again, the options ceases to exist.

Option type

As mentioned before, there are two types of options. There are call options and put options. Call options give the owner the right to buy shares while put options gives the owner the right to sell shares. In instances where one is bullish on a stock, a call option could be purchased to capture the upside at a fraction of the cost of the underlying security. In instances where one is bearish, a put option could be purchased to profit from a downtrend in the underlying security.

Exercise  price

Without the exercise  price, the option contract would be meaningless. The exercise  price is a price point of the underlying security that the holder of the call option can choose to buy the underlying security at. In the case of a put option, the Exercise  price is a price point of the underlying security at which a put option holder can buy the underlying security at. Remember that holders of options have the right but not the obligation to buy or sell the underlying security. And this of course is dependent on the moneyness  of the options contract, that is, if the options contract is in the money or out of the money. The moneyness of the options contract is in turn dependent on the movement of the underlying security’s price.

Premium

The options premium is the price that the buyer of the options contract must pay to the seller. Do remember that the buyer of an option has the right but not the obligation to buy or sell the underlying security. But the seller of the option has the obligation to buy or sell the underlying security. Yes! The seller has an obligation which is a certain risk on the seller’s part. The option buyer pays this premium to the option seller as a form of compensation. The value of the options premium is dependent on the volatility of the underlying security, the Exercise  price and the moneyness of the option, that is, whether the option is in the money or out of the money, and the time to expiration. The greater the volatility and the greater the time to expiration, the higher the premium for the option that a buyer has to pay.

The underlying security

The underlying security refers to the stocks on which the options are based or derived from. An option is just very simply a derivative of a security, in this case, the underlying security as it is most commonly called. When a buyer of an option chooses to exercise his right to buy or sell the option(although he is not obligated to do so), the seller has the obligation to sell the underlying security or buy the underlying security from the buyer of the option depending on whether it is a put or call option. The underlying security may be microsoft shares or shares of another publicly traded company listed on stock exchanges in the USA.

Option style

There are two styles to options. There are American styled options and European styled options. American styled options can be exercised at anytime before the expiration date while European styled options can only be exercised on the expiration day itself. The options that we are focused on are American styled options which are standard contract traded on exchanges in the U.S market. An example of European options is when Company A purchases an option to buy Company B for $100 million where the expiration date is the 1st of October 2017 and in which the contract specifies that the option can only be exercised by the company on the 1st of October 2017.

In any case, for the purposes of this topic on options trading, you should focus on : American styled options. It is not a big deal if you can really  differentiate between the two styles. Just know that when you trade, you trade American styled options.

Expiration date

After the expiration date of the options contract, an option ceases to exist and is now worthless. In a sense option contracts are essentially value decaying assets whose value decreases with time. The less time there is left to the expiration date, the less an option premium would be priced. For each option contract that is traded, the expiration month is specified and this information can be found on many websites. The expiration date of these contracts is the third Friday of the month in which these contracts expire.

Why does this even concern you?

Towards expiration date, your options have very little time value left in them. Therefore when you buy call options or put options which have very little time value left to them, be sure that you forsee a big price move in the underlying security.

Time value charts

If you are a call option or put option seller with very little time left towards expiration date, you are betting that there are no major price moves of the underlying security and hope for the options that you have written to expire worthless.

Time Value Chart

 

This is the April options chain of a company called IBM. At the time of this screenshot, IBM was trading at $144.80. As you can see above, some options trade at very small prices as they approach expiration date. These options are about to expire worthless.

Contract size

Each option contract represents 100 shares in an underlying security. That is, in the event that a call option contract is exercised, the seller of the option has to deliver 100 shares to the buyer of the contract. If a put option contract is exercised, the seller of the option has the obligation to buy a 100 shares underlying the contract.

Read:

Option Premium Is The Option Price

Understanding Option Strike price(Exercise price)