What is an Option?
An option can be defined as the right to buy or sell an asset at a fixed, predetermined price before a predetermined date. Buying options gives the buyer the right to buy (call option) or sell (put option) a stock at a specific price for a specified period of time. Let's be clear here, the buyer of this option is not obligated to buy or sell anything, an option is just that; it gives you the right.
Selling an option is a different story. When you sell an option short, you give the buyer of the option the right to force you to buy the security at a higher price (put) or deliver shares to the option buyer at a lower price (call) if the option is exercised. Selling naked options, or selling options without holding the underlying security, is more risky and should only be attempted by experienced traders. Naked options have unlimited risk.
An option has a few key components which govern the rules around exercising the option. The exercise (strike) price, expiration date and option type represent these rules. In this section, we will also cover the basics in options valuations as well.
Exercise price, aka. “strike price", refers to the price at which the option buyer can exercise his/her right to buy or sell the underlying security of the option contract. For example, lets say that you purchased 10 March call options on Merrill Lynch with a strike price of $60. As the purchaser of the option, you will have the right to buy 1000 shares of MER at $60. Now, you would have paid this premium to buy this stock at $60 only if you believe that it will be above that price by the expiration date of the option.
Expiration date refers to the date up until which the option can be exercised. In our example above, the expiration date of the Merrill Lynch option would be on options expiration in March. The value of a call option at expiration, as long as the last price is above the strike price, is the intrinsic value of the option or: (last traded price - strike price). Conversely, the value of a put option at expiration is: (exercise price - last traded price).
Options can be one of two types; American style or European style. The majority of all options traded are American style, and US equity options are all American style. The key difference between American and European options lies in the ability of the option holder to exercise the option. American style options are exercisable at any date up until options expiration while European style options are only exercisable at expiration. For this reason, American options command a higher premium.
Remember, options are a separate entity than the underlying security that they are derived from. They have their own ticker symbol and can be bought or sold at any time. We discussed the basic components of an option; strike price and expiration date. These represent price and time and therefore we can say that the price of an option is derived by adding up the intrinsic value and time value of the option.
Intrinsic value is basically the value of the option that is In the Money (ITM). Lets refer back to our Merrill Lynch example once again. If MER was trading at 65 when the strike price was 60, we can say that the option is in the money by $5. Time Value is the second portion of the option and this represents the value associated to the risk that remains for the seller of the option due to the time to expiration. For example, if we buy a 3 month option and a 9 month option, the intrinsic value on both will be the same; however, the 9 month option will have a greater time value component due to the greater time risk that the option seller is taking.
Out of the money calls (OTM) are options in which the current price of the underlying security is below the strike price. In this case, there is no intrinsic value and the option is made up of only time value. An option is said to be At the Money (ATM) when the last traded price is the same as the strike price of the option. Again, there is no intrinsic value for an ATM option, just the time value.
OTM puts work the opposite way; puts are considered OTM when the last traded price is higher than the strike price. Conversely, puts are considered in the money when the last traded price is lower than the strike price of the option.
We have just reviewed the very basics of options and options terminology. Options are great in that they allow you to control a large amount of stock with a relatively small amount of money. Options can be quite dangerous if not utilized properly; however, they can add quite a bit of safety to your portfolio as well if used properly. We will go on to discuss the many different types of options strategies that one could leverage for their specific scenario. To conclude, options provide quite a bit flexibility and allow you to greatly increase your gains if used properly while at the same time lowering your risk in the trade.
See You At the Top,
Kunal Vakil is the co-founder of mysmp.com (My Stock Market Power) which provides free trading articles to investors. Please visit http://www.mysmp.com/ for more free articles.