Options are financial instruments that can provide you with the
flexibility you need in almost any investment situation you might
encounter. Options give you options by giving you the ability to tailor
your position to your own 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 any investor should know as they learn
about equity options.
- An equity option is a contract which 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. The strike price, a fixed specification of an
option contract, should not be confused with the premium, the price at
which the contract trades, which fluctuates daily.
- Equity option strike prices are listed in increments of 1, 2 ½, 5, or 10 points, depending on their price level.
- Adjustments to an equity option contract's size and/or strike price may be made to account for stock splits or mergers.
- Generally, at any given time a particular equity option can be bought with one of four expiration dates.
- Equity option holders do not enjoy the rights due stockholders -
e.g., voting rights, regular cash or special dividends, etc. A call
holder must exercise the option and take ownership of underlying shares
to be eligible for these rights.
- Buyers and sellers in the exchange markets, where all trading is
conducted in the competitive manner of an auction market, set option
The two types of equity options are Calls and Puts.
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 prior to the options expiration date. The writer (or
seller) of the option has the obligation to buy the shares.
An option's price is called the "premium." The potential loss for the
holder of an option is limited to the initial premium paid for the
contract. The writer on the other hand has unlimited potential loss that
is somewhat offset by the initial premium received for the contract.
Investors can use put and call option contracts to take a position in a
market using limited capital. The initial investment would be limited to
the price of the premium.
Investors can also use put and call option contracts to actively hedge against
market risk. A put may be purchased as insurance to protect a stock holding
against an unfavorable market move while the investor still maintains stock
ownership. A call option on an individual stock issue may be sold, providing a
limited degree of downside protection in exchange for limited upside potential.
The security - such as XYZ Corporation - 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.
The Expiration day for equity options is the Saturday following the
third Friday of the month. Therefore, the third Friday of the month 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 proceeding this exchange holiday.
After the option's expiration date, the contract will cease 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.