What are options? Part 1

introduce

Options are a financial instrument that you can use flexibly in almost any investment environment you may encounter. You can use options to selectively set your positions according to your situation.

• You can protect the shares you own in the event of a decline in market prices.
• You can earn income on the stocks you own.
• You can prepare to buy stocks at low prices.
• Even if you don’t know how prices will move, you can be prepared for big market moves.
• You can benefit from rising or falling stock prices without buying the shares directly.

The following section provides basic terminology and explanations for any investor who wants to understand common stock options.

Common Stock Options Explained

• A common stock option is a contract that gives its holder the right (but not the obligation) to buy (in the case of a call option) or sell (in the case of a put option) a certain amount of the underlying asset at an agreed price (exercise price) on or before a fixed date (expiration date). After this fixed date, the option no longer exists. Similarly, at the option holder’s request, the option seller has the obligation to sell the option owner a certain number of shares (in the case of a call option) or buy a certain number of shares from the option owner (in the case of a put option) at the agreed price.
• Common stock options typically represent 100 shares of the underlying stock.
• The strike price (or exercise price) is the price per share of the underlying asset that the option owner will buy (in the case of a call option) or sell (in the case of a put option) if the option contract is exercised. The strike price is a fixed figure for an option contract. It should not be confused with the premium. The premium is the price at which an option trades and fluctuates daily.
• The strike price of common stock options is available in increments of 1, 2, 2 ½, 5, or 10 points at different price levels.
• It is possible that the size and/or exercise price of common stock option contracts may be adjusted to accommodate stock splits or mergers.
• Generally speaking, at any time, a common stock option may be purchased that has one of four expiration dates.
• The owner of a common stock option does not have the same rights as the owner of stock. These rights include voting rights, periodic cash or special dividends, etc. The owner of a call option must exercise the option and own the underlying stock to obtain these rights.
• In the trading market, all transactions are conducted in a competitive auction market. Buyers and sellers in the trading market determine the option price.

Call and Put Options

	Holder (buyer)	Writer (seller)
Call Option	The power to buy	Obligation to sell
Put Option	The power to sell	Obligation to buy

The two types of options are call options and put options.

A call option gives its holder the right to buy 100 shares of the underlying stock at the strike price at any time before the option expires. The option writer (or seller) has the obligation to sell these shares.

The opposite of a call option is a put option . A put option gives its owner the right to sell 100 shares of the underlying stock at the strike price at any time before the option expires. The option writer (or seller) has the obligation to buy these shares.

Option Premium

The price of an option is called the “premium.” An option owner’s potential loss is limited to the initial premium paid to purchase the option contract. The writer, on the other hand, has a potential unlimited loss. But this loss is somewhat offset by the initial premium received. To learn more about this, read our section on option pricing.

Investors can use call and put option contracts to open positions in the market with limited funds. The initial investment is limited to the price of the premium.

Investors can also actively hedge market risk using put and call contracts. Investors can purchase put options as insurance against adverse market fluctuations while still maintaining ownership of the stock.

Investors can sell call options based on individual stocks. This approach takes advantage of limited upside potential in exchange for some downside protection. Our strategies section lists the various option positions that investors can take and explains how options function in different market situations.

Underlying Securities

The underlying (say, XYZ Corp.) is the security that the option writer must deliver (in the case of a call option) or purchase (in the case of a put option) upon receipt of an exercise notice from the option contract owner.

Due Friday

The expiration date for common stock options is the Saturday following the third Friday of the expiration month. Therefore, the third Friday of that month is the last trading day for expiring common stock options .

This day is called “Expiration Friday”. If the third Friday of the month is an exchange holiday, the Thursday before the holiday is the last trading day.

After the expiration date of the option, the contract no longer exists. At this time, if the option owner does not fulfill the contract, he will not have the “right” given by the option before the expiration date, and the option seller will not have the “obligation” given by the option before the expiration date.