About Options

Option Contract

An option is a contract to buy or sell a specific underlying security. For equity options, the underlying instrument is a stock or exchange-traded fund (ETF). Many futures and commodity contracts also have listed options which give you the right to buy or sell the underlying commodity or instrument represented by the futures contract. The contract establishes a specific price, called the strike price, at which the contract may be exercised. An expiration date, after which, the contract no longer has value and no longer exists. Options come in two classes, calls and puts, and you can buy or sell either type. Your expectations for the underlying instrument will determine whether you buy or sell and whether to choose a call or a put.

Buying and Selling

If you buy a call, you have the right, but not the obligation, to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right, but not the obligation, to sell the underlying instrument on or before expiration. You can also choose to sell the option to another buyer anytime before expiration, or let the option expire worthless. If you “sell to open” an option, often referred to as writing or selling “naked” options, you in essence establish a short position where you are obligated to fulfill your side of the contract if the holder (buyer) decides to exercise. When you sell a call option as an opening transaction, you obligate yourself to sell the underlying instrument at the strike price, if it gets assigned. When you sell a put option as an opening transaction, you obligate yourself to buy the underlying instrument, if it gets assigned. As an option writer, you have no control over whether or not a contract is exercised, and you should be aware that assignment/exercise is always possible at any time until the expiration date. But as an option writer you also have the ability to purchase an offsetting contract to close your position, provided assignment hasn’t already occurred. When you “buy to close” you end your obligation to meet the terms of the contract.

Option Premium

The purchase price for an option is called a premium. As an option buyer you pay the premium, as an option seller/writer you receive the premium. Because the price of the underlying instrument is always fluctuating, the option premium changes constantly. When you buy an option, you have spent money that may never be recovered unless you are able to sell or exercise your option at a profit. Therefore, you create what is known as a net debit. If you do make money as an option buyer, you must subtract the cost of the premium from any income you realize to arrive at your net profit.

As a seller you begin with a net credit because you collect the premium for taking on the risk of assignment/exercise. If the option is never exercised, you keep the premium as your profit. If the option is exercised, you still keep the premium, however, you are obligated to buy or sell the underlying stock if you’re assigned.

The Value of Options

The biggest factor that determines what an option contract is worth, is known as intrinsic value. An option will have intrinsic value when the price of the stock or other underlying instrument is above the strike price for call options and below the strike price for put options. This is known as being “in-the-money”. Unless an option finishes in-the-money at expiration it is worthless. The second component that makes up an option’s value is known as time value or extrinsic value. Time value is the difference between whatever the intrinsic value is and what the premium is. The more time until expiration, the greater the time value.

Options Prices

There are several factors that affect the price of an option. The supply and demand in the market where the option is traded will have an affect on an option’s price. Volatility caused by uncertainty in the economy will affect the price of all listed options. Whereas, volatility around a specific company, maybe due to an earnings announcement, will affect only the option prices listed on that specific company.

Benefits and Risks

Options typically require less capital than equivalent stock transactions, and therefore allow one to potentially reduce risk. However, if less capital is risked, the investment will return a smaller dollar figure, even though the percent return on capital at risk will be much higher than an equivalent stock transaction.

Because options have the potential to return substantial gains on capital at risk, it is imperative that option trading is not viewed as a “get rich quick” scheme. Even though option buyers can risk a lot less capital to control an equivalent stock position, all options eventually expire worthless and one can lose the entire premium paid. Option writers/sellers take on even higher levels of risk. Sound money and risk management must always be used when trading options.

Options may not be appropriate for every investor, however, they are among the most flexible of investment choices. Depending on the contract, options can protect or enhance the portfolios of many different kinds of investors in rising, falling, and neutral markets.

Reducing Your Risk

Options can be a great tool for insuring a portfolio and managing risk. For example, if an investor believes the price of his shares in the ABC company are about to drop, he can purchase put options which give him the right to sell his stock at the strike price purchased, no matter how low the stock trades. Therefore, his risk, rather than be the entire price of the stock, becomes the premium paid for the put option plus the difference between the current stock price and the strike price, if the strike price was out of the money. This is known as hedging.

Some investors, rather than purchase shares of a specific company and then use put options as insurance, will choose to just purchase call option contracts to create an equivalent stock position thereby reducing their risk since the most that can be lost is the premium paid for the call options. These investors gain the right to buy or sell the underlying security at the strike price. Or, if they choose, they can sell the options back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher.

Many options strategies are designed to minimize risk by hedging existing portfolios and acting as a safety net. However, option transactions are not risk free. It’s important to understand all the risks associated with holding, writing, and trading options before you include them in your investment portfolio.