What are options? Part 2

Leverage and Risk

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.

Premium, parity, loss

An option’s strike price (exercise price) determines whether the option contract is in-the-money, at-the-money, or out-of-the-money. If a call option’s strike price is lower than the current market price of the underlying security, the call option is said to be in-the-money. This is because the owner of the call option has the right to buy the stock at a price lower than the market price. Similarly, if a put option’s strike price is higher than the current market price of the underlying security, it is also said to be in-the-money. This is because the owner of the put option has the right to sell the stock at a price higher than the market price. The opposite of premium is, of course, out-of-the-money. If the strike price is equal to the current market price, the option is said to be at-the-money.

The amount of premium a call or put option is worth at any time is called its intrinsic value. By this definition, options that are at or out of the money have no intrinsic value. Time value is the total option premium. However, this does not mean that these options are available for free. The portion of an option’s total premium that exceeds its intrinsic value is called the time value portion of the premium. The time value portion of an option’s premium is affected by volatility, interest rates, fluctuations in the amount of dividends, and the passage of time. There are other factors that affect the value of an option, and therefore the premium of an option trade. All of these factors together determine the time value.

Common Stock Call Option: Premium = Strike Price is Lower Than Stock Price Parity = Strike Price is Equal to Stock Price Out-of-the-Money = Strike Price is Higher Than Stock Price

Common Stock Put Option: Premium = Strike Price is Higher Than Stock Price Appraisal = Strike Price is Equal to Stock Price Out-of-the-Money = Strike Price is Lower Than Stock Price

Option premium: intrinsic value + time value

Time Weakness

An investor cannot close out a long call option position by purchasing a put option. The reverse is also true. A closing transaction of an option involves buying or selling an option contract of the same specification. This transaction can be made on any exchange where the option is traded. An investor who intends to close out an option position must complete the transaction before the close of trading on the last trading day of the option.

Generally speaking, the longer the option is until expiration, the higher the premium. This is because the longer the option is valid, the higher the probability that the underlying stock price will move into the money. With other factors that affect option prices unchanged, the time value portion of the option premium decreases (or weakens) as time passes.

Expiration Date

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. Note that this is the deadline by which brokers must submit exercise notices to the Options Clearing Corporation. However, the exchanges and brokers have rules and procedures regarding the deadline by which option owners must notify brokers of their intent to exercise. This deadline, also called the expiration deadline, is usually the third Friday of the expiration month before the expiration Saturday, sometime after the market closes. Ask your broker for the specific deadline. The last trading day for expiring common stock options is usually the third Friday before the expiration Saturday of the expiration month. If that Friday is an exchange holiday, the last trading day is the Thursday immediately preceding that holiday.

long

For the purposes of this section, the term long refers to a position in a stock or option that you have purchased and hold in your brokerage account. For example, if you purchased the right to buy 100 shares of a stock and hold that right in your brokerage account, you are long a call option. If you purchased the right to sell 100 shares of a stock and hold that right in your brokerage account, you are long a put option. If you purchased 1,000 shares of a stock and hold that stock in your brokerage account or elsewhere, you are long 1,000 shares of a stock. When you are long a common stock option contract:

• You have the right to exercise this option at any time before the option expires.
• Your potential loss is limited to the price you paid for the option contract.

Short

For the purposes of this section, a short position is an option position that you establish when you sell an option contract (but you do not own the contract). At the same time, you now have the obligation contained in the option contract. If the option owner exercises the contract, you are obligated to perform. If you sell someone the right to buy 100 shares of stock, you have a short call option. If you sell someone the right to sell 100 shares of stock, you have a short put option. When you sell an option contract, you are actually creating a contract. The writer of the option collects and keeps the premium from the initial sale of the option. When you are short a common stock option contract (you are the writer of the contract):

• You may be assigned an exercise notice at any time during the life of an option contract. All option writers should be aware that assignment prior to expiration is entirely possible.
• Your potential loss on a short call option could theoretically be unlimited. With a put option, the risk of loss is limited because the stock price cannot fall below zero. Although the loss is theoretically limited, the potential loss could still be huge if the underlying stock price falls too much.

Adding positions

A scaling trade is a trade that adds or starts a new trading position. It can be either a buy or a sell. For option trading, consider the following two aspects:

• Add-on Buy – A transaction whereby a buyer initiates or increases a long position in an option series.
• Adding Sell – A transaction used by a seller to initiate or increase a short position in a particular option series.

Closing a Position

Time weakness grows rapidly in the last few weeks of an option’s life. When an option is in-the-money at expiration, its value is usually its intrinsic value.

• Closing Buy – A transaction in which a buyer reduces or eliminates a short position in a particular option series. This transaction is often referred to as “covering” a short position.
• Closing Sell – A transaction by which a seller reduces or eliminates a long position in an option series.