What is an Option? Part 2

The Options Industry Council’s introduction to options

   

What is an Option? Part 2

Leverage and Risk

Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment’s percentage loss. Options offer their owners a predetermined, set risk. However, if the owner’s options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk.

In-the-money, At-the-money, Out-of-the-money…

The strike price, or exercise price, of an option determines whether that contract is in-the- money, at-the-money, or out-of-the-money. If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the stock market. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in-the-money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive selling the stock in the stock market. The converse of in-the-money is, not surprisingly, out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money.

The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option’s total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option’s premium that is affected by fluctuations in volatility, interest rates, dividend amounts, and the passage of time. There are other factors that give options value and therefore affect the premium at which they are traded. Together, all of these factors determine time value.

Equity Call Option
In-the-money = strike price less than stock price
At-the-money = strike price same as stock price
Out-of-the-money = strike price greater than stock price
Equity Put Option
In-the-money = strike price greater than stock price
At-the-money = strike price same as stock price
Out-of-the-money = strike price less than stock price

Remember: Option Premium = Intrinsic Value + Time Value

Time Decay

Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because the longer an option’s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.

Note – This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Expiration Day

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. Please note that this is the deadline by which brokerage firms must submit exercise notices to OCC; however, the exchanges and brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cut-off time, is generally on the third Friday of the month, before expiration Saturday, at some time after the close of the market. Please contact your brokerage firm for specific deadlines. The last day expiring equity options generally trade is also on the third Friday of the month, before expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day earlier, Thursday.

Long

With respect to this section’s usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account. For example, if you have purchased the right to buy 100 shares of a stock, and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock, and are holding that right in your brokerage account, you are long a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock. When you are long an equity option contract:

  • You have the right to exercise that option at any time prior to its expiration.
  • Your potential loss is limited to the amount you paid for the option contract.

Short

With respect to this section’s usage of the word, short describes a position in options in which you have written a contract (sold one that you did not own). In return, you now have the obligations inherent in the terms of that option contract. If the owner exercises the option, you have an obligation to meet. If you have sold the right to buy 100 shares of a stock to someone else, you are short a call contract. If you have sold the right to sell 100 shares of a stock to someone else, you are short a put contract. When you write an option contract you are, in a sense, creating it. The writer of an option collects and keeps the premium received from its initial sale. When you are short (i.e., the writer of) an equity option contract:

  • You can be assigned an exercise notice at any time during the life of the option contract. All option writers should be aware that assignment prior to expiration is a distinct possibility.
  • Your potential loss on a short call is theoretically unlimited. For a put, the risk of loss is limited by the fact that the stock cannot fall below zero in price. Although technically limited, this potential loss could still be quite large if the underlying stock declines significantly in price.

Open

An opening transaction is one that adds to, or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, consider both:

  • Opening purchase — a transaction in which the purchaser’s intention is to create or increase a long position in a given series of options.
  • Opening sale — a transaction in which the seller’s intention is to create or increase a short position in a given series of options.

Close

  • Closing purchase — a transaction in which the purchaser’s intention is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as “covering” a short position.
  • Closing sale — a transaction in which the seller’s intention is to reduce or eliminate a long position in a given series of options.

Note – An investor does not close out a long call position by purchasing a put, or vice versa. A closing transaction for an option involves the purchase or sale of an option contract with the same terms, and on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option’s last trading day.

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Article printed from InvestorPlace Media, http://investorplace.com/2011/03/what-is-an-option-part-2/.

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