Options can provide leverage. This means an option buyer can pay a relatively small
premium for market exposure in relation to the contract value (usually 100 shares
of the underlying stock). An investor can see large percentage gains from comparatively
small, favorable percentage moves in the underlying index. Leverage also has downside
implications. If the underlying stock price does not rise or fall as anticipated
during the lifetime of the option, leverage can magnify the investment's percentage
loss. Options offer their owners a predetermined, set risk. However, if the owner's
options expire with no value, this loss can be the entire amount of the premium
paid for the option. An uncovered option writer, on the other hand, may face unlimited
risk.
The strike price, or exercise price, of an option determines whether that contract
is in-the- money, at-the-money, or out-of-the-money. If the strike price of a call
option is less than the current market price of the underlying security, the call
is said to be in-the-money because the holder of this call has the right to buy
the stock at a price which is less than the price he would have to pay to buy the
stock in the stock market. Likewise, if a put option has a strike price that is
greater than the current market price of the underlying security, it is also said
to be in-the-money because the holder of this put has the right to sell the stock
at a price which is greater than the price he would receive selling the stock in
the stock market. The converse of in-the-money is, not surprisingly, out-of-the-money.
If the strike price equals the current market price, the option is said to be at-the-money.
The amount by which an option, call or put, is in-the-money at any given moment
is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money
option has no intrinsic value; the time value is the total option premium. This
does not mean, however, these options can be obtained at no cost. Any amount by
which an option's total premium exceeds intrinsic value is called the time value
portion of the premium. It is the time value portion of an option's premium that
is affected by fluctuations in volatility, interest rates, dividend amounts, and
the passage of time. There are other factors that give options value and therefore
affect the premium at which they are traded. Together, all of these factors determine
time value.
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Equity call option:
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In-the-money = strike price less than stock price
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At-the-money = strike price same as stock price
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Out-of-the-money = strike price greater than stock price
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Equity put option:
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In-the-money = strike price greater than stock price
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At-the-money = strike price same as stock price
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Out-of-the-money = strike price less than stock price
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Option Premium:
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Intrinsic Value + Time Value
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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.
Generally, the longer the time remaining until an option's expiration, the higher
its premium will be.
This is because the longer an option's lifetime, greater is the possibility that
the underlying share price might move so as to make the option in-the-money. All
other factors affecting an option's price remaining the same, the time value portion
of an option's premium will decrease (or decay) with the passage of time.
The expiration date is the last day an option exists. For listed stock options,
this is the Saturday following the third Friday of the expiration month. Please
note that this is the deadline by which brokerage firms must submit exercise notices
to OCC; however, the exchanges and brokerage firms have rules and procedures regarding
deadlines for an option holder to notify his brokerage firm of his intention to
exercise. This deadline, or expiration cut-off time, is generally on the third Friday
of the month, before expiration Saturday, at some time after the close of the market.
With respect to this section's usage of the word, long describes a position (in
stock and/or options) in which you have purchased and own that security in your
brokerage account. For example, if you have purchased the right to buy 100 shares
of a stock, and are holding that right in your account, you are long a call contract.
If you have purchased the right to sell 100 shares of a stock, and are holding that
right in your brokerage account, you are long a put contract. If you have purchased
1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere,
you are long 1,000 shares of stock. When you are long an equity option contract:
- You have the right to exercise that option at any time prior to its expiration.
- Your potential loss is limited to the amount you paid for the option contract.
With respect to this section's usage of the word, short describes a position in
options in which you have written a contract (sold one that you did not own). In
return, you now have the obligations inherent in the terms of that option contract.
If the owner exercises the option, you have an obligation to meet. If you have sold
the right to buy 100 shares of a stock to someone else, you are short a call contract.
If you have sold the right to sell 100 shares of a stock to someone else, you are
short a put contract. When you write an option contract you are, in a sense, creating
it. The writer of an option collects and keeps the premium received from its initial
sale. When you are short (i.e., the writer of) an equity option contract:
- You can be assigned an exercise notice at any time during the life of the option
contract. All option writers should be aware that assignment prior to expiration
is a distinct possibility.
- Your potential loss on a short call is theoretically unlimited. For a put, the risk
of loss is limited by the fact that the stock cannot fall below zero in price. Although
technically limited, this potential loss could still be quite large if the underlying
stock declines significantly in price.
With respect to this section's usage of the word, short describes a position in
options in which you have written a contract (sold one that you did not own). In
return, you now have the obligations inherent in the terms of that option contract.
If the owner exercises the option, you have an obligation to meet. If you have sold
the right to buy 100 shares of a stock to someone else, you are short a call contract.
If you have sold the right to sell 100 shares of a stock to someone else, you are
short a put contract. When you write an option contract you are, in a sense, creating
it. The writer of an option collects and keeps the premium received from its initial
sale. When you are short (i.e., the writer of) an equity option contract:
- Opening purchase -- a transaction in which the purchaser's intention is to create
or increase a long position in a given series of options.
- Opening sale -- a transaction in which the seller's intention is to create or increase
a short position in a given series of options. .
- Closing purchase -- a transaction in which the purchaser's intention is to reduce
or eliminate a short position in a given series of options. This transaction is
frequently referred to as "covering" a short position.
- Closing sale -- a transaction in which the seller's intention is to reduce or eliminate
a long position in a given series of options.