The first step in understanding options trading, is to identify the parties involved in a transaction.
An investor, who makes the opening purchase, is known as the buyer, holder or owner and establishes a long position in the option. The buyer has the right to exercise the contract they have purchased. The buyer pays the writer a premium for the right to exercise according to the terms specified in the contract.
The investor who makes the opening sale is called the writer. This person is short the options contract. Once the transaction has taken place, the writer now has an obligation to the buyer of the option, should that buyer exercise the contract. The writer receives a premium from the buyer for this obligation.
An investor owning an option contract who grants the rights of the option to another buyer. This transaction includes both the closing sale for the seller and the opening purchase for the buyer. The buyer of the contract pays a premium to the seller.
Classification of Options
An option gives the holder of the contract (buyer) the right to purchase or sell the underlying security at a specified price, which is referred to as the strike price within a specified amount of time.
Types of Options
There are two types of options, a call option and a put option.
A call option grants the buyer or holder of the contract the right to buy 100 shares of the underlying security from the writer or seller of the contract at a specified price. Should the buyer exercise the option, the writer is obligated to deliver the stock.
A put option grants the buyer or holder of the contract, the right to sell 100 shares of the underlying security to the writer or seller of the contract at a specified price. Should the buyer exercise the option, the writer is obligated to buy the stock.
Class of Options
Class of options is identified as option contracts of a single type and style that cover the same underlying security.
Series of Options
An option series consists of all options of the same class, having the same date of expiration and strike price.
Style of Option
American Style Option
An American Style Option can be exercised at any time from the date of purchase to the date of expiration. As a general rule, most option contracts that are exchange-traded are American Style.
European Style Option
A European Style Option can only be exercised on the last business day prior to expiration. This system is widely used with Index options.
Components of an Option
The underlying security is the stock to be either bought or sold should an option contract be exercised.
Each equity option contract represents 100 shares of the underlying security.
All listed options have dates of expiration, which is the last day that an option can be exercised. Listed options cease trading on the third Friday of every month and expire the following Saturday at 11:59 p.m. Eastern Time. If the option is out of the money and therefore not exercised, it is said that the option has expired worthless.
The exercise price is also known as the Strike Price. This is the price at which the buyer may either purchase or sell the underlying security, according to the contract with the writer or seller.
Aggregate Exercise Price
This is the number of shares represented by an options contract, usually 100, multiplied times the exercise or strike price. For example, if the exercise price specified on a contract is $60, then the aggregate exercise price will be $6,000.
It is the exercise price of an options contract in relation to the current trading price of the underlying security that determines whether the contract is in, at or out of the money.
An option that is in-the-money means the option possesses intrinsic value. For example, a call option where the underlying security is trading at a price higher than the strike price of the contract, is said to be in-the-money.
An option that is out-of-the-money possesses no intrinsic value. For example, a call option where the underlying security is trading at a price lower than the strike price of the contract is said to be out-of-the-money. If the contract remains out- of-the-money through to the date of expiration, it will expire worthless.
An option where the underlying security is trading at parity with the strike price specified in the contract is said to be at-the-money.
The premium is the price paid by a buyer of the option contract to the writer. The premium is also the current market price of the option.
Premiums are quoted using points. For example, you may see ABC Jun-55 calls @ 4. To determine the actual premium, multiply the premium (in this case, it is 4) times the option contract size of 100. For this example, the buyer would pay the writer $400 for one contract on ABC.
The premium of an option is determined by two factors, which are intrinsic value and time value.
Intrinsic Value is the difference between the exercise price specified in an options contract and the market price of the underlying security.
Time Value is the amount that an options premium exceeds its intrinsic value. This reflects the time remaining on the option contract before expiration in relation to its premium. The time value of an option decreases as the date of expiration approaches.
Option Premium = Intrinsic Value + Time Value
Long Term Equity Options - Long term equity options are better known as LEAPS and can have expirations up to three years out from the date of purchase. One of the advantages to purchasing a LEAP, is their time value decreases at a much slower rate than shorter term options. They are also valuable tools for providing long term protection on stock positions and offer the potential to profit from the price movement of a stock over time.