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Q.
What is an option? |
A.
An option is a contract giving
the owner the right to either buy or sell something (in this case a
security), at a specified price (the strike or exercise price), before
a specified deadline (the expiration date).
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Q.
What is an option buyer? |
A.
An
option buyer is an investor who pays the premium and acquires the
rights that the particular option contract carries. He or she may
be said to be long the option.
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Q.
What is an option premium? |
A.
An option premium is the amount of money paid by a buyer, or received
by a seller, for an option contract. When the underlying security
is common stock, in most cases one option contract covers 100 shares
of the underlying stock, and the premium quoted is the premium per
share of stock controlled, not the premium for the entire contract.
When buying options, you must pay the premium in full plus commissions.
The premium is equal to the intrinsic value of the option plus a time
value.
Example: If the premium (price) of an option contract
is 4, the amount you would have to pay to control (have the right
to buy or sell) 100 shares would be $400. If you were to write
or sell the option, you would receive $400.
(a)
(b) (c) (d) (e)
IBM
Nov 60 call @ 4
-
The
underlying stock: IBM
-
The
expiration month: November
-
The
strike price: $60
-
The
type of contract (put or call): Call
-
The
premium: $4
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Q.
What is the expiration date? |
A.
The expiration date is the date on which an
option expires. If the owner of an option does not exercise or sell
the option by the expiration date, it becomes worthless. Most option
contracts have an expiration date of around ninety days from the time
they start trading. All listed options expire at 11:59 P.M. on the
Saturday following the third Friday of the expiration month.
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Q.
What is the exercise of an option? |
A.
The exercise of an option means that the owner
of the contract exercises his or her rights. In this case, the seller
of the contract must fulfill his or her obligation under the contract.
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Q.
What is a strike price? |
A.
The
strike price, also referred to as the exercise price, of an option
contract is the price at which the owner has the option, or right,
to buy or sell the underlying security. Strike prices are established
by the exchange on which the options are traded. For each underlying
security, there will be several strike prices clustered around the
price of the underlying security at the time the options are first
traded. As the range within which the underlying security trades moves
up or down, the exchange will establish new contracts with strike
price reflecting current prices of the underlying security.
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Q.
Where are options traded? |
A.
Options are traded on the following exchanges:
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Q.
What happens if the price of the underlying security increases? |
A.
If
the price of the underlying security increases, there are two things
you can do: you can exercise the option, or you can sell it. If you
exercise the option, you must pay the full strike price of the underlying
security plus a commission; then you can either sell the security
at the higher market price (less commission). If you sell the option,
you will make a profit equal to the increase in the price of the call-which,
because of the time value, is not necessarily the same as the increase
in the price of the underlying security.
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Q.
What do I have if I buy a call? |
A.
If
you buy a call, you have the right to buy the underlying security
at the strike price at any time before the expiration date.
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Q.
What is a call? |
A.
A call is a contract giving you the right to buy a security.
In the case of an option on common stock, it is a contract giving
you the right to buy 100 shares of a stock at a specified price before
or on a specified date.
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Q.
What are the types of options? |
A.
There are two types of options: calls and puts.
-
Buying
a call gives you the right to buy the underlying security.
-
Buying
a put gives you the right to sell the underlying security.
-
Selling
a call gives you the obligation to sell the underlying
security if the buyer of the option wishes to buy it.
-
Selling
a put gives you the obligation to buy the underlying
security if the buyer of the option wishes to sell it.
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Q.
If I buy an option contract and the price of the underlying security moves
in a favorable direction, do I have to exercise the option? |
A.
No.
You can sell your option contract. This is called closing
the contract.
Note:
If you are the seller of a contract and the
price of the underlying stock starts moving in a direction that
puts you in a loss position, you may want to buy an option contract
to close your position and cut your possible losses.
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Q.
What are the choices that an option buyer has? |
A.
Option
buyers have three choices:
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Q.
What does buying or selling an option really mean? |
A.
Buying
an option gives you rights until the expiration date. Selling an option
imposes obligations on you until the expiration date.
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Q.
What is an option writer? |
A.
An
option writer, or seller, is an investor who receives
the premium and is obligated to perform the responsibilities that
the particular option contract carries. He or she may be said to be
short the option.
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Q.
What is a covered call? |
A.
A
writer, or seller, of call options against stocks he or she already
owns is said to be writing a covered call. In this case,
the risk of selling a call is that you may be required to sell your
stock if the call owner exercises his or her option. This is referred
to as having your stock called away.
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Q.
Why would I sell a call contract? |
A.
The
basic reason for selling a call contract is to increase your return
on a security whose price you expect to remain the same or decline
during the life of the contract. The seller receives the premiums
paid by the buyer and, in return, agrees to deliver the underlying
stock if the stock price rises above the strike price and the option
is exercised. If the option writer is correct and the stock price
does not rise, the premium provides him or her with an increased rate
of return. Other objectives for selling calls might be:
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Q.
What happens if I write (sell) a call contract? |
A.
If
you are the writer, or seller, of a call contract, you have the obligation
to sell 100 shares of the underlying security at the strike price
up to the expiration date if the buyer chooses to exercise the option.
Example: If
you write (sell) one IBM November 50 call at $4, up to the expiration
date of the contract in November, you have the obligation to deliver
100 shares of IBM stock if the call buyer exercises the
option. You receive $400 ($4 times 100 shares) less commissions
as the premium for selling this contract. If a call buyer does
exercise the option, you have, in effect, sold 100 shares of IBM
stock for $5,400 ($5,000 [$50 times 100 shares] for the stock
plus the $400 premium). If the call buyer does not exercise
the option before expiration, you have earned $400.
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Q.
How do I go about exercising a call that I own? |
A.
If
you own a call contract and the price of the underlying stock has
increased, you can request your broker to exercise your contract.
You will be buying 100 shares of the underlying stock for the strike
price plus a commission.
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Q.
What happens if the price of the underlying security remains the same
or decreases? |
A.
If
the price of the underlying security has not increased sufficiently
by the expiration date, you would not exercise your option; it would
expire worthless. Your only loss would be the premium you paid for
the option plus the commission.
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Q.
What happens if I want to exercise a put that I own? |
A.
If
you own a put contract and the price of the underlying stock has declined,
you can request your broker to exercise your contract. You will then
be selling 100 shares of the underlying stock for the strike price
less a commission.
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Q.
What happens if the price of the underlying security decreases? |
A.
If
the price of the underlying security decreases, there are two things
you can do: you can exercise the option, you will receive the strike
price for the underlying security less a commission; If you sell the
option, you will make a profit equal to the increase in the price
of the put.
Example:
If
you buy one IBM December 60 put at $2 1/2, you own the right to
sell 100 shares of IBM at $60 per share at any time before the
option expires in December. The cost of the contract is $250 ($2
1/2 times 100 shares).
If
the price of IBM decreases to $52 by the expiration date, you
could exercise your option and sell 100 shares at
$60 per share less commission. (Note: your true proceeds would
be $57.50 per share-$60 less the premium of $2 1/2). Alternatively,
instead of selling your shares, you could simply sell your contract,
since its value would have risen as the value of the common stock
fell. In this example, it should have risen to about $8 (depending
on the time value), so you could sell it for $8 and realize a
profit of $5.50 ($8 less $2 1/2 cost) per share.
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Q.
Why would I buy a put? |
A.
There
are several reasons why you might buy a put, but one of the most popular
is to guard against a possible decline in the price of a stock that
you own. This is an alternative to selling (writing) a call against
the stock. By buying the put instead, you have the right to sell your
stock, not an obligation to do so.
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Q.
What do I have if I buy a put? |
A.
If
you buy a put, you have the right to sell the specified security at
the strike price at any time before the expiration date.
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Q.
What is a put? |
A.
A
put is a contract giving the buyer the right to sell
a security. In the case of an option on common stock, it is a contract
giving the buyer the right to sell 100 shares of the underlying stock
at a specified price before or on a specified date.
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Q.
Can I sell a call without owning the underlying stock? |
A.
Yes.
You may write (sell) a call without owning the underlying stock. Doing
so is called writing a naked call (the opposite of a
covered call). You run the risk that the stock price will increase
sharply, leaving you in the position of having to deliver shares of
a greatly appreciated stock that you do not own. Writing naked calls
is not appropriate for the average investor because of this high risk.
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Q.
What are some of the terms I need to know if I am going to trade in options? |
A.
If
you decide to invest in options, some of the terms you should know
are:
-
Opening
transaction.
-
Closing
transaction.
-
In
the money.
-
Out
of the money.
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Q.
When is the settlement date for option trades? |
A.
Unlike
stock and bond transactions, option transactions settle the day after
the trade date. For this reason, an option investor should have a
cash reserve or a money market fund at the brokerage firm.
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Q.
Will I be issued a certificate for an option contract? |
A.
No.
Because options are very short-time instruments, the issuance of certificates
would not be practical.
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Q.
Why would I sell a put contract? |
A.
The
most common reason to sell a put contract is to increase your income
by receiving the premium. As a seller of a put contract, you would
be betting that the stock price would continue to rise and that you
would keep the premium. If you were forced to buy the stock, your
net cost would be lowered by the amount of the premium you received.
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Q.
When might an option contract be considered insurance? |
A.
Options
are generally thought of as speculative investments. They are not
investments that are usually suitable for novice investors. However,
when an option is used in conjunction with a stock holding, it may
be thought of as insurance.
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Q.
What does the time value of an option mean? |
A.
The
time value of an option contract refers to the fact
that an option contract is a wasting asset. The amount of time left
in an option contract has a value to the buyer of the option. As the
expiration date draws nearer, the time value diminishes. A buyer is
usually willing to pay more for a contract that has a longer time
outstanding than for one that is about to expire.
How
time value enters into the pricing of an option is a complex subject
and is beyond the scope of this FAQs page. However, in general, it
is safe to say that as the expiration date gets closer, option contracts
tend to sell near or at their intrinsic value.
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Q.
Why do in-the-money options sell at premium above their intrinsic value? |
A.
The
premium for an in-the-money option will reflect a time value as well
as the intrinsic value.
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Q.
What is an option's intrinsic value? |
A.
When
an option is in the money, the difference between the strike price
and the stock price is said to be the option's intrinsic value.
Out-of-the-money contracts have no intrinsic value.
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Q.
What does out of the money mean? |
A.
A
call is said to be out of the money when
the price of the underlying stock is lower than the
strike price of the call.
A
put is said to be out of the money when the
price of the underlying stock is higher than the strike
price of the put.
Market
price of Underlying Stock Put Call
Above
strike price Out of the money In the money
Below
strike price In the money Out of the money
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Q.
What does in the money mean? |
A.
A
call option contract is said to be in the money
when the market price of the underlying stock is higher than
the strike price of the option. For example, an IBM November 70 call
is in the money by 10 points when the price of IBM stock is at $80.
A
put option contract is said to be in the money
when the stock price is lower than the strike price
of the option. For example, and IBM November 70 put is in the money
by 10 points when the stock is selling for $60.
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Q.
What are index options? |
A.
Index
options are a type of instrument developed several years ago
to allow investors to purchase or sell options on a group of securities
intended to reflect movement in the market or a particular industry,
not a particular stock. The investor has to be right only on the direction
of the market, not the direction of an individual stock.
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Q.
What is an options spread? |
A.
An
option spread is a strategy in which an option trader will
simultaneously buy one option position on an underlying stock and
sell a different option on the same stock. Usually, the two positions
will have different strike prices, expiration dates, or both. Both
positions may be calls, or both may be puts.
Example:
You could buy one IBM December 50 put and
sell one IBM March 55 put.
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Q.
I have heard of options straddle. What are they? |
A.
A
straddle is the buying or selling of both a put and
a call with the same exercise price and expiration date on the underlying
stock. The buyer has locked in a price at which he or she can either
buy or sell the underlying stock. The buyer is betting on the stock's
price volatility. All that the buyer needs in order to make a profit
is a large enough movement in the price of the underlying stock in
either direction.
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Q.
I have heard of options combinations. What are they? |
A.
Option
combinations are similar to straddles
except that the expiration dates or strike prices will often be different.
Example:
You could buy one IBM January 50 call and one IBM February 60 put.
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Q.
What is the risk in selling calls against a stock I currently own? |
A.
The
risk in selling calls against a stock you currently own is that if the
price of the stock increases beyond a certain point, the owner of the
calls will exercise the options. You will have to either deliver the
stock from your portfolio or buy stock in the open market to make delivery.
If
you deliver stock from your own portfolio, you will be taxed on any
profit. You will have a capital gain of the difference between what
you paid for the stock and the exercise price.
If
you want to avoid the capital gain, you may purchase shares of the
stock after you receive the call notice to make delivery. This allows
you to keep your original shares.
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Q.
Do options on foreign currencies trade? |
A.
Yes.
Options based on the value of several foreign currencies trade on
the options exchanges. The valuation of options on foreign currencies
is very difficult, and so these options should be avoided by all but
very experienced or professional investors.
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Q.
Can I invest in interest-rate options? |
A.
Yes.
There are various interest-rate option contracts that trade on the
American Stock Exchange and the Chicago Board Options Exchange. The
contracts are based on baskets of bonds, mostly U.S. Treasury securities.
There are also options on GNMA securities and certificates of deposit.
Note of Caution:
Because interest rates and bond prices move
in opposite directions, using interest rate options requires a
different thought process from trading in stock or index options.
Interest-rate options should be avoided by most investors, particularly
novice investors.
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Q.
If I buy one OEX put option, what do I have? |
A.
If
you buy one OEX put option, you have the right to sell the value of
the basket of stocks at your strike price until the expiration date.
It the value of the stocks included in the index declines, the value
of your put contract will increase. If you buy an OEX put with a strike
price of $325 and the index's value declines to $300, the value of
your put should increase by about $2,500 ($25 times 100) less commissions.
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Q.
If I buy one OEX call option, what do I have? |
A.
If
you buy one OEX call option, you have the right to buy the value of
the basket of stocks at your strike price until the expiration date.
If you buy one OEX November 325 call and the value of the OEX index
increases to $325, the value of a call on the index will increase
to about $33,500 less commissions.
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Q.
How do OEX contracts trade? |
A.
Just
like any option contract, OEX contracts are assigned expiration dates
and strike prices based on the value of the index. If the value of
the OEX index is $325, each contract will control $32,500 (100 times
$325).
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Q.
How can I determine the value of an OEX contract? |
A.
Financial
tables giving the value of OEX contracts are published in most newspapers.
Also, the updated values can be retrieved on the quote machines on
brokers' desks.
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Q.
What is the prospectus? |
A.
The
prospectus contains a full description of option types
and the risks involved in this type of investment. The prospectus
is published by the OCC and must be made available to investor.
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Q.
What is an option agreement? |
A.
An
option agreement clarifies the investor's rights and
obligations in option trading. Every investor must sign this agreement,
affirming that he or she has read the agreement and is aware of the
risks of option trading.
Prior to buying
or selling an option, a person must receive a copy of
Characteristics
and
Risks of Standardized Options.
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Q.
What is an option disclosure statement? |
A.
An
option disclosure statement is a document discussing
the risks of trading options. It must be provided to an investor at
or before the time at which the investor is approved for option trading.
You
may review the Option Disclosure Statement by clicking
on
Characteristics
and Risks of Standardized Options.
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For
many years, investors could buy or sell options only on stocks traded
on one of the exchanges. However, over the last few years, investors
have become able to buy or sell options on a broad range of investments,
such as stock market indexes, interest rates, US Treasury securities,
and foreign
-
Source:
Money & Investing Victor L. Harper., Arthur S. Brinkley.,
With Sarah E. Dale
|
What
is the exercise of an option?
What
are the types of options?
What
happens if the price of the underlying security remains the same
or decreases?