What is an Option?

An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product.

The contract has a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.

Options come in two varieties, calls and puts. and you can buy or sell either type. You make those choices — whether to buy or sell and whether to choose a call or a put — based on what you want to achieve as an options investor.

Options Compared To Common Stocks

Similarities

Both options and stocks are listed securities. Orders to buy and sell options are handled through brokers in the same way as orders to buy and sell stocks. Listed option orders are executed on the trading floors of national SEC-regulated exchanges where all trading is conducted in an open, competitive auction market. Like stocks, options trade with buyers making bids and sellers making offers. In stocks, those bids and offers are for shares of stock. In options, the bids and offers are for the right to buy or sell 100 shares (per option contract) of the underlying stock at a given price per share for a given period of time. Option investors, like stock investors, have the ability to follow price movements, trading volume and other pertinent information day by day or even minute by minute. The buyer or seller of an option can quickly learn the price at which his order has been executed.

Differences

Unlike common stock, an option has a limited life. Common stock can be held indefinitely in the hope that its value may increase, while every option has an expiration date. If an option is not closed out or exercised prior to its expiration date, it ceases to exist as a financial instrument. For this reason, an option is considered a wasting asset. There is not a fixed number of options, as there is with common stock shares available. An option is simply a contract involving a buyer willing to pay a price to obtain certain rights and a seller willing to grant these rights in return for the price. Thus, unlike shares of common stock, the number of outstanding options (commonly referred to as open interest) depends solely on the number of buyers and sellers interested in receiving and conferring these rights. Unlike stocks which have certificates evidencing their ownership, options are certificateless. Option positions are indicated on printed statements prepared by a buyer’s or seller’s brokerage firm. Certificateless trading, an innovation of the option markets, sharply reduces paperwork and delays. Finally, while stock ownership provides the holder with a share of the company, certain voting rights and rights to dividends (if any), option owners participate only in the potential benefit of the stock’s price movement.

Buying and Selling

If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless.

The situation is different if you write. or sell to open. an option. Selling to open a short option position obligates you, the writer, to fulfill your side of the contract if the holder wishes to exercise. When you sell a call as an opening transaction, you’re obligated to sell the underlying interest at the strike price, if you’re assigned. When you sell a put as an opening transaction, you’re obligated to buy the underlying interest, if assigned. As a writer, you have no control over whether or not a contract is exercised, and you need to recognize that exercise is always possible at any time until the expiration date. But just as the buyer can sell an option back into the market rather than exercising it, as a writer you can purchase an offsetting contract, provided you have not been assigned, and end your obligation to meet the terms of the contract. When offsetting a short option position, you would enter a buy to close transaction.

Premium

When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn’t fixed and changes constantly — so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow.

An option’s premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the premium is. The longer the amount of time for market conditions to work to your benefit, the greater the time value.

Expiration Day

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. Please contact your brokerage firm for specific deadlines. The last day expiring equity options generally trade is also on the third Friday of the month, before expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day earlier, Thursday.