The fundamentals of listed options
What options are?
What makes up an option?
The benefits of trading options
What is an Option?
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset).
An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
Listed options have been available since 1973, when the Chicago Board Options Exchange, still the busiest options exchange in the world, first opened.
The World with and without Options:
Prior to the founding of the CBOE, investors had few choices of where to invest their money; they could either be long or short individual stocks, or they could purchase treasury securities or other bonds.
Once the CBOE opened, the listed option industry began, and investors now had a world of investment choices previously unavailable.
In order for you to better understand the benefits of trading options, you must first understand some of the similarities and differences between options and stocks.
Options Vs. Stocks
Similarities:
Listed Options are securities, just like stocks.
Options trade like stocks, with buyers making bids and sellers making offers.
Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
What options are?
What makes up an option?
The benefits of trading options
What is an Option?
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset).
An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
Listed options have been available since 1973, when the Chicago Board Options Exchange, still the busiest options exchange in the world, first opened.
The World with and without Options:
Prior to the founding of the CBOE, investors had few choices of where to invest their money; they could either be long or short individual stocks, or they could purchase treasury securities or other bonds.
Once the CBOE opened, the listed option industry began, and investors now had a world of investment choices previously unavailable.
In order for you to better understand the benefits of trading options, you must first understand some of the similarities and differences between options and stocks.
Options Vs. Stocks
Similarities:
Listed Options are securities, just like stocks.
Options trade like stocks, with buyers making bids and sellers making offers.
Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.
Differences:
Options are derivatives, unlike stocks(i.e, options derive their value from something else, the underlying security).
Options have expiration dates, while stocks do not.
There is not a fixed number of options, as there are with stock shares available.
Stockowners have a share of the company,with voting and dividend rights. Options convey no such rights.
Options are derivatives, unlike stocks(i.e, options derive their value from something else, the underlying security).
Options have expiration dates, while stocks do not.
There is not a fixed number of options, as there are with stock shares available.
Stockowners have a share of the company,with voting and dividend rights. Options convey no such rights.
Call Options and Put Options
Some people remain puzzled by options. The truth is that most people have been using options for some time, because option-ality is built into everything from mortgages to auto insurance. In the listed options world, however, their existence is much more clear.
To begin, there are only two kinds of options: Call Options and Put Options.
A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits.
If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned.
If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument increases.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price, called the strike price.
If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.
Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases.
If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.
With a Put Option, you can "insure" a stock by fixing a selling price.
If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level.
If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium.
This is the primary function of listed options, to allow investors ways to manage risk.
Options Premiums
In this case, XYZ represents the option class while May 30 is the option series. All options on company XYZ are in the XYZ option class but there will be many different series.
An option Premium is the price of the option. It is the price you pay to purchase the option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZ stock) may have an option premium of $2.
This means that this option costs $200.00. Why? Because most listed options are for 100 shares of stock, and all equity option prices are quoted on a per share basis, so they need to be multiplied times 100. More in-depth pricing concepts will be covered in detail in other sections of the course.
NOTE: There are times when an options contract is adjusted for an amount other than 100 shares as a result of a merger or stock split.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract.
For example, with the XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 per share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock at $30 per share.
The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security. You will learn about these terms in another section of the course.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist. The expiration date for all listed stock options in the U.S. is the third Friday of the month (except when it falls on a holiday, in which case it is on Thursday).
For example, the XYZ May 30 Call option will expire on the third Friday of May.
Types of Options
Here is a pictorial overview of the rights and obligations of people who buy options (called "holders") and those who sell options (called "writers").
Exercising Options
People who buy options have a Right, and that is the right to Exercise.
For a Call Exercise, Call holders may buy stock at the strike price (from the Call seller).
For a Put Exercise, Put holders may sell stock at the strike price (to the Put seller).
Neither Call holders nor Put holders are obligated to buy or sell; they simply have the rights to do so, and may choose to Exercise or not to Exercise based upon their own logic.
Assignment of Options
When an option holder chooses to exercise an option, a process begins to find a writer who is short the same kind of option (i.e., class, strike price and option type). Once found, that writer may be Assigned.
This means that when buyers exercise, sellers may be chosen to make good on their obligations.
For a Call Assignment, Call writers are required to sell stock at the strike price to the Call holder.
For a Put Assignment, Put writers are required to buy stock at the strike price from the Put holder.
Using Equity Calls
Let's do an example. Assume for a moment that it is April 5th, and you are following XYZ, which is presently at $29 a share. You think that this stock will go up in price in the next month and a half or so, to well past $30 a share.
Knowing about options, you choose to buy an XYZ May 30 Call for 2, instead of buying the stock outright. This option gives you the right to buy 100 shares of XYZ Stock at $30 a share any time before May expiration
NOTE: For this right, you pay $200. Remember, all prices need to be multiplied by 100, since all options are usually for 100 shares.
Values of the Call
Here's what happens. Remember, you bought the XYZ May 30 Call. On expiration Friday, assume XYZ is at $35 per share. You have a Call option, which can be exercised to purchase 100 shares of XYZ Stock at $30 per share.
If you do that, you can then sell that stock back in the market and make a $5 return per share, or $500. Since your initial Call premium was $200, your net profit is $300.
You could also keep the stock, if you choose, knowing you got to buy it at a discount to the present value.
Or, you could simply sell the option back in the market, at any time before expiration, and take the profit on the option itself.
NOTE: Most options are never exercised; holders choose to take their profits simply by trading out of the options.
If you had been wrong about XYZ and it had gone down to $25 a share, your only loss would be the premium amount you paid for the Call, $200 ($2 per share), since the option would be worthless.
Let's do another example. Assume it is a few days later and you have bought some XYZ, and at a price of $31/share.
It is now at $32 a share, but you are concerned that an adverse market move may cause you to lose money on your XYZ stock position, though you are not afraid enough to sell the stock.
You could buy an XYZ Aug 30 Put for 1, which would give you the right to sell your stock at a price of $30 a share in the event XYZ goes down in value.
For every 100 shares you own, you would buy one Put, and for this right, you pay $100.
Here's what happens. Since you bought the XYZ Aug 30 Put, you have the right to sell your stock to someone at $30 a share, no matter how low it goes.
In this sense, it is like an insurance policy on your stock, fixing your maximum risk at $200. ($1 cost of the Put option and the $1 you could lose on each of your 100 shares if it falls from your purchase price of $31 to your exercise price of $30).
However, if the stock does decline to, say, $29 a share, you do not have to exercise the Put.
Since you are the holder, you have the choice, and you may decide to simply sell the Put back in the market and continue holding the stock.
The position you get is reflected in the diagram at the left, and is identical to being long a Call. It has a limited risk, with unlimited upside.
These previous examples introduced how options can provide investors with more alternatives, allowing them to specify, precisely, the amount of risk they are willing to take in their holdings.
If used on a 1-to-1 basis with the underlying shares, then options can be used to invest in stocks with limited risk, to insure stock investments held, or to set levels of market exposure consistent with one's investment strategy.
Options can also be used as alternatives to stock investments (one option for each 100 shares), giving investors the ability to profit from favorable market moves just as if they held the underlying security, but with lower potential risk due to a lower initial investment.
Given the numerous opportunities that options convey, it is also important to know that there are options available which can be used to implement longer-term strategies (not one, two or three months, but those with holding times of one, two or more years).
These are called LEAPS (for Long Term Equity Anticipation Securities), and are yet another alternative that options offer to investors.
LEAPS are options with expiration dates of up to three years from the date they are first listed, and are available on a number of individual stocks and indexes.
LEAPS have different ticker symbols than short-term options (options with less than nine months until expiration) and, while not available on all stocks, are available on most widely held issues and can be traded just like any other options.
Each of the following multiple choice questions will test your understanding of this lesson.
Some people remain puzzled by options. The truth is that most people have been using options for some time, because option-ality is built into everything from mortgages to auto insurance. In the listed options world, however, their existence is much more clear.
To begin, there are only two kinds of options: Call Options and Put Options.
A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits.
If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned.
If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument increases.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price, called the strike price.
If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.
Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases.
If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.
With a Put Option, you can "insure" a stock by fixing a selling price.
If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level.
If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium.
This is the primary function of listed options, to allow investors ways to manage risk.
Options Premiums
In this case, XYZ represents the option class while May 30 is the option series. All options on company XYZ are in the XYZ option class but there will be many different series.
An option Premium is the price of the option. It is the price you pay to purchase the option. For example, an XYZ May 30 Call (thus it is an option to buy Company XYZ stock) may have an option premium of $2.
This means that this option costs $200.00. Why? Because most listed options are for 100 shares of stock, and all equity option prices are quoted on a per share basis, so they need to be multiplied times 100. More in-depth pricing concepts will be covered in detail in other sections of the course.
NOTE: There are times when an options contract is adjusted for an amount other than 100 shares as a result of a merger or stock split.
Strike Price
The Strike (or Exercise) Price is the price at which the underlying security (in this case, XYZ) can be bought or sold as specified in the option contract.
For example, with the XYZ May 30 Call, the strike price of 30 means the stock can be bought for $30 per share. Were this the XYZ May 30 Put, it would allow the holder the right to sell the stock at $30 per share.
The strike price also helps to identify whether an option is In-the-Money, At-the-Money, or Out-of-the-Money when compared to the price of the underlying security. You will learn about these terms in another section of the course.
Expiration Date
The Expiration Date is the day on which the option is no longer valid and ceases to exist. The expiration date for all listed stock options in the U.S. is the third Friday of the month (except when it falls on a holiday, in which case it is on Thursday).
For example, the XYZ May 30 Call option will expire on the third Friday of May.
Types of Options
Here is a pictorial overview of the rights and obligations of people who buy options (called "holders") and those who sell options (called "writers").
Exercising Options
People who buy options have a Right, and that is the right to Exercise.
For a Call Exercise, Call holders may buy stock at the strike price (from the Call seller).
For a Put Exercise, Put holders may sell stock at the strike price (to the Put seller).
Neither Call holders nor Put holders are obligated to buy or sell; they simply have the rights to do so, and may choose to Exercise or not to Exercise based upon their own logic.
Assignment of Options
When an option holder chooses to exercise an option, a process begins to find a writer who is short the same kind of option (i.e., class, strike price and option type). Once found, that writer may be Assigned.
This means that when buyers exercise, sellers may be chosen to make good on their obligations.
For a Call Assignment, Call writers are required to sell stock at the strike price to the Call holder.
For a Put Assignment, Put writers are required to buy stock at the strike price from the Put holder.
Using Equity Calls
Let's do an example. Assume for a moment that it is April 5th, and you are following XYZ, which is presently at $29 a share. You think that this stock will go up in price in the next month and a half or so, to well past $30 a share.
Knowing about options, you choose to buy an XYZ May 30 Call for 2, instead of buying the stock outright. This option gives you the right to buy 100 shares of XYZ Stock at $30 a share any time before May expiration
NOTE: For this right, you pay $200. Remember, all prices need to be multiplied by 100, since all options are usually for 100 shares.
Values of the Call
Here's what happens. Remember, you bought the XYZ May 30 Call. On expiration Friday, assume XYZ is at $35 per share. You have a Call option, which can be exercised to purchase 100 shares of XYZ Stock at $30 per share.
If you do that, you can then sell that stock back in the market and make a $5 return per share, or $500. Since your initial Call premium was $200, your net profit is $300.
You could also keep the stock, if you choose, knowing you got to buy it at a discount to the present value.
Or, you could simply sell the option back in the market, at any time before expiration, and take the profit on the option itself.
NOTE: Most options are never exercised; holders choose to take their profits simply by trading out of the options.
If you had been wrong about XYZ and it had gone down to $25 a share, your only loss would be the premium amount you paid for the Call, $200 ($2 per share), since the option would be worthless.
Let's do another example. Assume it is a few days later and you have bought some XYZ, and at a price of $31/share.
It is now at $32 a share, but you are concerned that an adverse market move may cause you to lose money on your XYZ stock position, though you are not afraid enough to sell the stock.
You could buy an XYZ Aug 30 Put for 1, which would give you the right to sell your stock at a price of $30 a share in the event XYZ goes down in value.
For every 100 shares you own, you would buy one Put, and for this right, you pay $100.
Here's what happens. Since you bought the XYZ Aug 30 Put, you have the right to sell your stock to someone at $30 a share, no matter how low it goes.
In this sense, it is like an insurance policy on your stock, fixing your maximum risk at $200. ($1 cost of the Put option and the $1 you could lose on each of your 100 shares if it falls from your purchase price of $31 to your exercise price of $30).
However, if the stock does decline to, say, $29 a share, you do not have to exercise the Put.
Since you are the holder, you have the choice, and you may decide to simply sell the Put back in the market and continue holding the stock.
The position you get is reflected in the diagram at the left, and is identical to being long a Call. It has a limited risk, with unlimited upside.
These previous examples introduced how options can provide investors with more alternatives, allowing them to specify, precisely, the amount of risk they are willing to take in their holdings.
If used on a 1-to-1 basis with the underlying shares, then options can be used to invest in stocks with limited risk, to insure stock investments held, or to set levels of market exposure consistent with one's investment strategy.
Options can also be used as alternatives to stock investments (one option for each 100 shares), giving investors the ability to profit from favorable market moves just as if they held the underlying security, but with lower potential risk due to a lower initial investment.
Given the numerous opportunities that options convey, it is also important to know that there are options available which can be used to implement longer-term strategies (not one, two or three months, but those with holding times of one, two or more years).
These are called LEAPS (for Long Term Equity Anticipation Securities), and are yet another alternative that options offer to investors.
LEAPS are options with expiration dates of up to three years from the date they are first listed, and are available on a number of individual stocks and indexes.
LEAPS have different ticker symbols than short-term options (options with less than nine months until expiration) and, while not available on all stocks, are available on most widely held issues and can be traded just like any other options.
Each of the following multiple choice questions will test your understanding of this lesson.
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