This page of our SIE Study Guide provides a thorough review of options along with important facts and strategies.
Options are contracts between two investors. These contracts trade on a specific securities exchange, the largest of which is the Chicago Board Options Exchange (CBOE).
Types of Options
Call Options: Gives the owner of the call option the right (but not the obligation) to buy a certain underlying asset or security on or before the expiration date of the contract.
Put Options: Gives the owner of the put option the right (but not the obligation) to sell a certain underlying asset or security on or before the expiration date of the contract.
In every option contract there is a buyer and a seller:
Selling vs. Buying: The seller, also known as the writer, receives a premium (fee) in exchange for giving the buyer the right to buy or sell an underlying asset at a specific price on or before the contract’s expiration date. The writer has a legal obligation to deliver or purchase the underlying asset if the option is exercised.
“The right but not the obligation” means the owner can decide whether to exercise their right. There are no requirements to do so.
Premium: When option contracts are bought and sold, the market price to be paid for the contract fluctuates throughout the day based upon supply and demand just like the market prices of corporate stocks. The word used for the market price of an option contract is premium; the buyer pays the premium and the seller receives the premium.
Underlying Assets: An option is a type of derivative product, meaning its value is wholly dependent upon the value of its underlying asset (which can fluctuate). The most common underlying asset is stock. For example, if you purchase a stock option that gives you the right to purchase shares of Company ABC for $10, then the underlying asset would be Company ABC’s stock.
- Other underlying assets include foreign currency (British Pounds, Japanese Yen, etc.), market indices (such as the S&P 500 Index), debt securities, and more.
Strike Price: The contractually agreed upon price at which a call or put option can be exercised. Also known as the exercise price.
Expiration date: The date at which an options contract expires, ranging from a week after purchase to several years. Options with longer lives are typically more expensive.
Intrinsic Value: Since the prices of option contracts can fluctuate, they have the potential to be in the money, out of the money, or at the money, which all affect the option’s intrinsic value. Using stock as an example, these different situations are described below.
- In the Money: A call option is said to be in the money if the current price of the underlying stock is trading at a higher price than the strike price. If the holder were to exercise their right to purchase the underlying stock, then they would get to pay less than its current value, giving the call intrinsic value. A put option is said to be in the money if the current price of the underlying stock is trading at a lower price than the strike price. If the holder were to exercise their right to sell the underlying stock, then they would receive more than what they paid for, giving the put intrinsic value.
- Out of the Money: Option contracts that are out of the money do not have any intrinsic value. A call option is said to be out of the money if current price of the underlying stock is trading at a lower price than the strike price. A put option is said to be out of the money if the current price of the underlying stock is trading at a higher price than the strike price. The holders in these scenarios would not exercise their rights to buy or sell.
- At the Money: An option is at the money whenever the current price of the underlying stock equals the strike price. There is no intrinsic value.
- Examples: If you have the right to buy 100 shares of IBM stock at a strike price of $125, and IBM is trading on the New York Stock Exchange right now at $140, then your right to buy at $125 provides you with an opportunity to save $15 per share. It is that savings that is referred to as the intrinsic value, also called in the money value. Conversely, if the current price of IBM dropped to $115, then the option would be $10 out of the money and you would typically not exercise your right to buy.
Risk Mitigation/Hedging: Though option contracts are bought and sold for a variety of reasons, they are commonly used as a way to reduce exposure to investment losses. Known as hedging, investors can lower the risk of one investment by taking a position in another investment. Using stock as an example, some popular hedging strategies are described below.
Covered Call Writing: An investor who owns 100 shares of stock decides to write a call option on those 100 shares, contractually offering it for sale at a fixed (strike) price for a fixed period of time (expiration) in exchange for a premium. The dollar amount of the premium received provides downside protection in the event the stock they own declines in value, though a loss would occur if the decline in value is greater than the premium received. Conversely, the gain is capped at the amount by which the strike price exceeds the stock’s current market price. This strategy of writing a call on stock the investor already owns is known as covered call writing.
Protective Put Buying: An investor who owns 100 shares of stock decides to purchase a put option on those 100 shares, contractually locking in a fixed (strike) price at which they may sell their stock in the event it declines in value. They have to pay a premium for this contractual right to fix the price at which they may sell their shares, but if the stock declines dramatically then the premium cost will have been worth it. The protection against loss is the reason an investor may decide to use this strategy known as protective put buying.
Capital Gains: Buying a call when one believes the stock will rise in price or buying a put when one believes the stock will fall in value can both generate substantial upside profit (capital gains).
Buy to Cover: An investor who believes a stock price will decline might decide to borrow shares from a broker, immediately sell them at the current market price, and then, after the market price has declined, return the borrowed shares by buying them back on the open market.
Options Clearing Corporation (OCC): Located in Chicago, the OCC clears put and call option transactions, among other transactions, under the supervision of the Commodities Futures Trading Commission (CFTC) and the SEC.
Options Disclosure Document (ODD): When an investor wants to open an options account at a brokerage firm, the firm is first required to provide them with a full disclosure document at or prior to account approval. This document, known as the Options Disclosure Document (ODD), educates clients about how options work, their potential risks, and the rules of the CBOE and the OCC.
American vs. European: Some options contracts are only allowed to be exercised on the expiration date, which is referred to as European-style. The premiums on these contracts are typically lower. American-style options, on the other hand, allow for the contract to be exercised at any time, up to and including the expiration date.
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