How Options Work

Todd MitchellOptions are the most versatile trading instrument ever invented. Since options cost less than stock, they provide a high leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income. Simply put, options buyers have rights and options sellers have obligations. Buyers have the right, but not the obligation, to buy (call) or sell (put) the underlying stock (or futures contract) at a specified price until the 3rd Friday of their expiration month. There are two kinds of options: calls and puts. Call options give you the right to buy the underlying asset. Put options give you the right to sell the underlying asset. It is essential to become familiar with the inner workings of both. Just about all strategies you learn depend on your thorough understanding of these two kinds.

There are no margin requirements if you want to purchase options because your risk is limited to the price. In contrast, sellers receive a credit in their account for selling options and get to keep this amount if the options expire worthless. However, sellers also have an obligation to buy (put) or sell (call) the underlying instrument if their option is exercised by an assigned option holder. Therefore, selling an option requires a healthy margin.

To trade options, you must be acquainted with the select terminology of the market. The price at which an underlying stock can be purchased or sold if the option is exercised is called the strike price. Options are available in several strike prices above and below the current price of the underlying asset. Stocks priced below $25 per share usually have strike prices at 2 ½ dollar intervals. Stocks priced over $25 usually have strike prices at $5 dollar intervals.

The date that options expire is referred to as the expiration date. Stock options expire by close of business on the 3rd Friday of the expiration month. All listed options have options available for the current month and the next month as well as specific future months. Each stock has a corresponding cycle of months that they offer options in. There are three fixed expiration cycles available. Each cycle has a four-month interval:

  1. January, April, July and October
  2. February, May, August and November
  3. March, June, September and December

The price is called the premium. A premium is determined by a number of factors including the current price of the underlying asset, the strike price, the time remaining until expiration, and volatility. A premium is priced on a per share basis. Each option on a stock corresponds to 100 shares. Therefore, if the premium is priced at 2, the total premium for that option would be $200 (2 x 100 = $200). Buying creates a debit in the amount of the premium to the buyer’s trading account. Selling creates a credit in the amount of the premium to the seller’s trading account:

Example: Jane wants to buy a house. After a few weeks of searching, she discovers one she really likes. Unfortunately, she won’t have enough money for a substantial down payment for another six months. So, she approaches the owner of the house and negotiates an option to buy the house within 6 months for $100,000. The owner agrees to sell her the option for $2,000.

Scenario 1: During this 6-month period, Jane discovers an oil field underneath the property. The value of the house shoots up to $1,000,000. However, the writer of the option (the owner) is obligated to sell the house to Jane for $100,000. Jane buys the house for a total cost of $102,000-$100,000 for the house plus the $2,000 premium paid for the option. She promptly turns around and sells it for a million dollars for huge profit of $898,000 and lives happily ever after.

Scenario 2: Jane discovers a toxic waste dump on the property. Now the value of the house drops to zero and she obviously decides not to exercise the option to buy the house. In this case, Jane loses the $2,000 premium paid for the option to the owner of the property.

How Options Work Review

Options . . .

  1. Give you the right to buy or sell an underlying instrument.
  2. If bought, do not  obligate you to buy or sell the underlying instrument; you simply have the right to.
  3. If sold and exercised, obligate you to deliver the underlying asset (call) or take delivery of the underlying asset (put) at the strike price regardless of the current price of the underlying asset.
  4. Are good for a specified period of time, after which they expire and you lose your right to buy or sell the underlying instrument at the specified price.
  5. When bought are done so at a debit to the buyer.
  6. When sold are done so by giving a credit to the seller.
  7. Are available in several strike prices representing the price of the underlying instrument.
  8. Have a cost referred to as the option premium. The price reflects a variety of factors including the current price of the underlying asset, the strike price, the time remaining until expiration, and volatility.
  9. Are not available on every stock. There are approximately 2,200 stocks with tradable options. Each stock option represents 100 shares of a company’s stock.