What Is An Option?
In the world of investing and finance, there are many terms and concepts that are often misunderstood by many investors.
Some commonly misunderstood issues include the concepts of selling stock short, what a derivatives contract is, credit default swaps, and dividend arbitrage strategies.
One of the more common concepts that is misunderstood by investors is the options contract.
What Exactly Is An Option Contract?
While an option contract may seem confusing at first glance, it is actually far simpler than it is made out to be.
Let's start with a very basic definition of what an option is:
An option gives the buyer the right but not the obligation to buy or sell the underlying at a certain price by a certain date in the future.
An option is exactly that-the option to be long or short the underlying at a certain price by a certain date in the future.
An option contract is always based on an underlying contract or shares.
In the case of stock, one option contract equals 100 shares of the stock.
In futures, one option equals one contract of the underlying future.
Options Have Set Price Levels Called Strike Prices
Options always entail a specific price which is called the strike or striking price.
This option strike price is the price at which one may have the right to buy or sell the underlying contract.
The strike price is often referred to as the exercise price.
An option will always have a strike price.
Some underlying contracts will have more strike prices than others.
Inexpensive stocks for example, may have strike price increments of $2.50 while more moderately priced stocks may have increments of $5.00 with very expensive stocks having even larger increments.
Let's look at an example:
Let's suppose that an investor is trading shares of TTT which is currently trading at $25 per share.
Let's further suppose that this investor believes that the shares may rise in the near future but does not want to commit the necessary capital to buy the shares outright.
The investor may elect to purchase a call option instead.
In this particular case, the investor may elect to purchase the front month $27.50 call option.
This call option would give the investor the right but not the obligation to buy the shares or be long the shares from $27.50 at any time until expiration.
Let's assume that after the investor buys this option that the shares skyrocket to $30 per share.
If the investor has the right to be long from $27.50, then the investor would be looking at a gain on the shares of $2.50 per share minus whatever premium he or she paid for the option.
Although we will address call and put options more specifically in future articles, it is very important that one have a thorough understanding of how an option works before looking to utilize options strategies.
Options Always Have An Expiration Date
When an option is listed, it will always have an expiration date.
There are many different types of expiration dates these days, and likely more will be introduced in the future.
Different stocks and different products may also have differing expiration dates.
For example, most heavily traded stocks will have options that expire each month.
These options expire on the third Friday of each month.
Some stocks will also have end-of-month options listed as well as weekly options listed.
The point is that every option has a finite lifespan.
Because options have a finite lifespan, an option will experience time decay otherwise known as theta decay during the course of its life all else remaining equal.
Theta is one of the more well known option greeks and must be well understood in order to use options.
Why do options have an expiration date?
Well, one way to look at an option contract is a leveraged transfer of risk.
In many regards, the idea of an option contract is similar to an insurance policy.
When one buys an insurance policy, there is always a time frame attached to it.
Many policies must be renewed each year.
During the policy term, you pay the insurance company a premium to assume the risk of loss during that time period.
Once the term expires, the insurance company is no longer assuming that risk unless the policy is renewed and another premium is paid.
Options are very similar in that the seller of an option assumes the risk of a stock or underlying contract making a specific move.
The option seller, like the insurance company, is paid a premium.
Once that option expires however, the option seller is no longer assuming the risk.
Options Can Be In, Out, or At-The-Money
When looking at options contracts, a contract may be in-the-money, out-of-the-money, or at-the-money.
An in-the-money option is an option whose strike price is above or below the current price of the underlying.
For example, if shares of JJJ are trading at $50 per share and one owns the $45 call, that call option would be considered in-the-money because the shares are already trading above the strike price.
Using the same example, if one owns the $50 call option, that option would be considered at-the-money because it is at the level that the underlying shares are trading at currently.
Finally, the $55 call option would be considered out-of-the-money because the underlying shares are not at or above the strike price of $55.
An Option's Value Is Known As The Premium
When options are traded, the value of an option is known as the premium.
This premium is the price at which one can buy or sell the option. In other words, when an investor wants to buy the right but not the obligation to buy or sell a stock at a certain price by a certain date in the future, he or she will pay the option seller a premium.
If the option expires worthless, then the seller keeps the premium.
Option premiums can have fairly narrow or fairly wide bid/ask spreads.
These are often quoted by market makers whose job it is to make a market in that particular option.
Market makers look to profit from the ability to buy the bid and sell the offer.
The investing public however, does not have this ability and when trading options will likely buy the offer or sell the bid or perhaps transact somewhere in between these levels.
Option contracts that trade for smaller premiums such as less than $3.00 will often trade in $.05 increments while options trading at larger premiums will trade in increments of $.10.
There Are Two Types of Option Value
Option contracts consist of two types of value which are known as intrinsic and extrinsic.
Intrinsic value is the option's value derived from being in-the-money while extrinsic value is derived from the option's time value.
Options may consist of both types of value at the same time, or may consist entirely of one or the other.
For example, an out-of-the-money option will consist entirely of extrinsic or time value while a deep in-the-money option will consist of almost entirely intrinsic value.
There Are Many Option Based Strategies Available
Options contracts may be bought, sold, or be bought and sold in various combinations.
There are two types of options contracts which are known as calls and puts.
Option strategies may be utilized to attempt to hedge existing positions, make a directional bet on a stock or market, or take advantage of the passage of time by trying to profit from time decay.