What is an Option? Part 1
Introduction
What are options? 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 an introduction to options trading including basic terms and descriptions that any investor should know as they learn about this form of equity.
Describing 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 options contract 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 prices.
Calls and Puts
| Holder (Buyer) | Writer (Seller) | |
|---|---|---|
| Call Option | Right to Buy | Obligation to Sell |
| Put Option | Right to Sell | Obligation to Buy |
The two types of equity options are Calls and Puts. A call option gives its holder the right to buy 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 sell the shares.
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.
The Options Premium
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. For more information go to our Options Pricing section.
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. Our information on types of options strategies shows various options positions an investor can take and explains how options can work in different market scenarios.
Underlying Security
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.
Expiration Friday
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.
To continue our introduction to options trading, read more in part 2.
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