What is an Option? Part 1

by The Options Industry Council | March 6, 2011 5:36 pm

Introduction

Options are financial instruments that can provide you with the flexibility you need in almost any investment situation you might encounter. Options give you options by giving you the ability to tailor your position to your own situation.

The following information provides the basic terms and descriptions that any investor should know as they learn about equity options.

At any time you may email us at: options@theocc.com[1] or call 1-888-OPTIONS for further discussion on these or other topics.

Describing Equity Options

Calls and Puts

The two types of equity options are Calls and Puts.

A call option gives its holder the right to buy 100 shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to sell the shares.

The opposite of a call option is a put option, which gives its holder the right to sell 100 shares of the underlying security at the strike price, anytime prior to the options expiration date. The writer (or seller) of the option has the obligation to buy the shares.

Holder (Buyer) Writer (Seller)
Call Option Right to buy Obligation to sell
Put Option Right to sell Obligation to buy

The Options Premium

An option’s price is called the “premium.” The potential loss for the holder of an option is limited to the initial premium paid for the contract. The writer on the other hand has unlimited potential loss that is somewhat offset by the initial premium received for the contract. For more information go to our Options Pricing[2] section.

Investors can use put and call option contracts to take a position in a market using limited capital. The initial investment would be limited to the price of the premium.

Investors can also use put and call option contracts to actively hedge against market risk. A put may be purchased as insurance to protect a stock holding against an unfavorable market move while the investor still maintains stock ownership.

A call option on an individual stock issue may be sold, providing a limited degree of downside protection in exchange for limited upside potential. Our Strategies Section[3] shows various options positions an investor can take and explains how options can work in different market scenarios.

Underlying Security

The security – such as XYZ Corporation – an option writer must deliver (in the case of call) or purchase (in the case of a put) upon assignment of an exercise notice by an option contract holder.

Expiration Friday

The Expiration day for equity options is the Saturday following the third Friday of the month. Therefore, the third Friday of the month is the last trading day for all expiring equity options.

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

After the option’s expiration date, the contract will cease to exist. At that point the owner of the option who does not exercise the contract has no “right” and the seller has no “obligations” as previously conveyed by the contract.

Read more[4]

 

Endnotes:

  1. options@theocc.com: mailto:options@theocc.com
  2. Options Pricing: /basics/options_pricing.jsp
  3. Strategies Section: /strategy/default.jsp
  4. Read more: http://what_is_2.jsp

Source URL: https://investorplace.com/2011/03/what-is-an-option-part-1/