What is an Option?
An option is a contract that allows you to buy (call option) or sell (put option) a certain amount of an underlying stock (usually 100 shares unless adjusted for a split or other corporate action) at a specific price (strike price) for a set amount of time (any time prior to its expiration).
A call option gives the buyer the right to buy 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a call option is obligated to sell the stock at the strike price if the option is exercised.
A put option gives the buyer the right to sell 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a put option is obligated to purchase the stock at the strike price if exercised.
Strike (or Exercise) Price
The strike price is the price per share at which the holder can purchase (for call options) or sell (for put options) the underlying stock.
Exercise is the process by which an option buyer (holder/owner) invokes the terms of the option contract. When exercising, call owners will buy the underlying stock, while put owners will sell the underlying stock under the terms set by the option contract. All option contracts that are in-the-money (i.e. have at least one cent of intrinsic value) at expiration will be automatically exercised.
The expiration date is the last day on which the option may be exercised. Monthly listed stock options cease trading on the third Friday of each month and expire the next day. Weekly options cease trading on Friday of that week.
Hedging is a conservative strategy used to reduce investment risk by implementing a transaction that offsets an existing position.
A covered call is another risk-reducing strategy; in this, a call option is written (sold) against an existing stock position on a share-for-share basis. The call is said to be “covered” by the underlying stock, which could be delivered if the call option is exercised.
The price of an option is made up of two parts, the intrinsic value and the time value. The intrinsic value of an option is the amount of profit that can be theoretically obtained if the option is exercised at that moment and the stock either purchased (for calls) or sold (for puts) at the current market price. If an option has positive intrinsic value, it is said to be “in-the-money” (ITM) and if it has negative intrinsic value it is said to be “out-of-the-money” (OTM). For instance, an XYZ May 25 Call priced at $3.00 when the stock is trading at $26.50 would have $1.50 of intrinsic value if the stock were trading at $26.50, regardless of its market price at the time.
Time value is the amount by which an option’s market price exceeds its intrinsic value. In the case above with the XYZ May 25 Call priced at $3.00 while XYZ stock is trading at $26.50, the intrinsic value is $1.50 and the rest is time value, in this case, the remaining $1.50 is time value. If an option is out-of-the-money (i.e. has no intrinsic value) then the entire market price is considered time value or time premium.
The price of an option is called its premium. Prices are quoted per share, but premium is usually the entire dollar value of the contract (price per share X 100 shares = total premium).
All options are wasting assets whose time value erodes to zero by expiration. This erosion is known as time decay. The closer an option is to expiring, the greater the erosion in value.
To be “long” an option simply means to have purchased it in an opening transaction and thus to own or hold it in a stock or an option.
Being short has two meanings. If one is short a stock, this means they have sold shares they do not own. To be short an option simply means to have sold the option and collected the premium in an opening transaction. (A short position is carried as a negative on a statement and must be purchased later to close out.)
LEAPS (Long-term Equity AnticiPation Securities)
These are long-term options with expiration dates as far out as three years, usually expiring in January.