Subject: Derivatives - Stock Option Basics

Last-Revised: 26 May 1999
Contributed-By: Art Kamlet (artkamlet at aol.com), Bob Morris, Chris Lott (contact me), Larry Kim (lek at cypress.com)

An option is a contract between a buyer and a seller. The option is connected to something, such as a listed stock, an exchange index, futures contracts, or real estate. For simplicity, this article will discuss only options connected to listed stocks.

Just to be complete, note that there are two basic types of options, the American and European. An American (or American-style) option is an option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-Style. All stock options are American style. A European (or European-style) option is an option contract that can only be exercised on the expiration date. Futures contracts (i.e., options on commodities - see the article elsewhere in this FAQ) are generally European-style options.

Every stock option is designated by:

  • Name of the associated stock
  • Strike price
  • Expiration date
  • The premium paid for the option, plus brokers commission.

The two most popular types of options are Calls and Puts. We'll cover calls first. In a nutshell, owning a call gives you the right (but not the obligation) to purchase a stock at the strike price any time before the option expires. An option is worthless and useless after it expires.

People also sell options without having owned them before. This is called "writing" options and explains (somewhat) the source of options, since neither the company (behind the stock that's behind the option) nor the options exchange issues options. If you have written a call (you are short a call), you have the obligation to sell shares at the strike price any time before the expiration date if you get called.

Example: The Wall Street Journal might list an IBM Oct 90 Call at $2.00. Translation: this is a call option. The company associated with it is IBM. (See also the price of IBM stock on the NYSE.) The strike price is 90. In other words, if you own this option, you can buy IBM at US$90.00, even if it is then trading on the NYSE at $100.00. If you want to buy the option, it will cost you $2.00 (times the number of shares) plus brokers commissions. If you want to sell the option (either because you bought it earlier, or would like to write the option), you will get $2.00 (times the number of shares) less commissions. The option in this example expires on the Saturday following the third Friday of October in the year it was purchased.

In general, options are written on blocks of 100s of shares. So when you buy "1" IBM Oct 90 Call at $2.00 you actually are buying a contract to buy 100 shares of IBM at $90 per share ($9,000) on or before the expiration date in October. So you have to multiply the price of the option by 100 in nearly all cases. You will pay $200 plus commission to buy this call.

If you wish to exercise your option you call your broker and say you want to exercise your option. Your broker will make the necessary requests so that a person who wrote a call option will sell you 100 shares of IBM for $9,000 plus commission. What actually happens is the Chicago Board Options Exchange matches to a broker, and the broker assigns to a specific account.

If you instead wish to sell (sell=write) that call option, you instruct your broker that you wish to write 1 Call IBM Oct 90s, and the very next day your account will be credited with $200 less commission. If IBM does not reach $90 before the call expires, you (the option writer) get to keep that $200 (less commission). If the stock does reach above $90, you will probably be "called." If you are called you must deliver the stock. Your broker will sell IBM stock for $9000 (and charge commission). If you owned the stock, that's OK; your shares will simply be sold. If you did not own the stock your broker will buy the stock at market price and immediately sell it at $9000. You pay commissions each way.

If you write a Call option and own the stock that's called "Covered Call Writing." If you don't own the stock it's called "Naked Call Writing." It is quite risky to write naked calls, since the price of the stock could zoom up and you would have to buy it at the market price. In fact, some firms will disallow naked calls altogether for some or all customers. That is, they may require a certain level of experience (or a big pile of cash).

When the strike price of a call is above the current market price of the associated stock, the call is "out of the money," and when the strike price of a call is below the current market price of the associated stock, the call is "in the money." Note that not all options are available at all prices: certain out-of-the-money options might not be able to be bought or sold.

The other common option is the PUT. Puts are almost the mirror-image of calls. Owning a put gives you the right (but not the obligation) to sell a stock at the strike price any time before the option expires. If you have written a put (you are short a put), you have the obligation to buy shares at the strike price any time before the expiration date if you get get assigned. A put is "in the money" when the strike price is above the current market price of the stock, and "out of the money" when the strike price is below the current market price. Then there are covered puts, which means you are short the stock at the same time as you write the put; also see the FAQ article on covered puts. Covered puts are a simple means of locking in profits on the covered security, although there are also some tax implications for this hedging move. Check with a qualified expert.

How do people trade these things? Options traders rarely exercise the option and buy (or sell) the underlying security. Instead, they buy back the option (if they originally wrote a put) or sell the option (if the originally bought a call). This saves commissions and all that. For example, you would buy a Feb 70 call today for $7 and, hopefully, sell it tommorow for $8, rather than actually calling the option (giving you the right to buy stock), buying the underlying stock, then turning around and selling the stock again. Paying commissions on those two stock trades gets expensive.

Although options offically expire on the Saturday immediately following the third Friday of the expiration month, for most mortals, that means the option expires the third Friday, since your friendly neighborhood broker or internet trading company won't talk to you on Saturday. The broker-broker settlements are done effective Saturday. Another way to look at the one day difference is this: unlike shares of stock which have a 3-day settlement interval, options settle the next day. In order to settle on the expiration date (Saturday), you have to exercise or trade the option by Friday. While most trades consider only weekdays as business days, the Saturday following the third Friday is a business day for expiring options.

The expiration of options contributes to the once-per-quarter "triple-witching day," the day on which three derivative instruments all expire on the same day. Stock index futures, stock index options and options on individual stocks all expire on this day, and because of this, trading volume is usually especially high on the stock exchanges that day. In 1987, the expiration of key index contracts was changed from the close of trading on that day to the open of trading on that day, which helped reduce the volatility of the markets somewhat by giving specialists more time to match orders.

You will frequently hear about both volume and open interest in reference to options (really any derivative contract). Volume is quite simply the number of contracts traded on a given day. The open interest is slightly more complicated. The open interest figure for a given option is the number of contracts outstanding at a given time. The open interest increases (you might say that an open interest is created) when trader A opens a new position by buying an option from trader B who did not previously hold a position in that option (B wrote the option, or in the lingo, was "short" the option). When trader A closes out the position by selling the option, the open interest either remain the same or go down. If A sells to someone who did not have a position before, or was already long, the open interest does not change. If A sells to someone who had a short position, the open interest decreases by one.

For anyone who is curious, the financial theoreticians have defined the following relationship for the price of puts and calls. The Put-Call parity theorem says:

    P = C - S + E + D

Where:

  • P = price of put
  • C = price of call
  • S = stock price
  • E = present value of exercise price
  • D = present value of dividends

The ordinary investor will occasionally see a violation of put-call parity. This is not an instant buying opportunity, it's a reason to check your quotes for timeliness, because at least one of them is out of date.

My personal advice for new options people is to begin by writing covered call options for stocks currently trading below the strike price of the option; in jargon, to begin by writing out-of-the-money covered calls.

The following web resources may also help.

  • For the last word on options, contact The Options Clearing Corporation (CCC) at 1-800-OPTIONS and request their free booklet "Characteristics and Risks of Listed Options." This 94-page publications will give you all the details about options on equity securities, index options, debt options, foreign currency options, principal risks of options positions, and much more. The booklet is published jointly by the American Stock Exchange, The Chicago Board Options Exchange, The Pacific Exchange, and The Philadelphia Stock Exchange. It's available on the web at:
    http://www.optionsclearing.com/about/publications/character-risks.jsp
  • The Chicago Board Options Exchange (CBOE) maintains a web site with extensive information about equity and index options. Visit them at:
    http://www.cboe.com
  • The Orion Futures Group offers an "Options 101" primer.
    http://www.orionfutures.com/opts.htm

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