An option is a contract to buy or sell a specific financial product officially known as the option's underlying instrument. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.
Buying and/or Selling
If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless – it should be noted that these options are usually sold prior to expiration.
The situation is different if you write, or "sell to open", an option – this is referred to as a short position. Selling an option to open a trade obligates you, the writer, to fulfill your side of the contract if the holder (the buyer) wishes to exercise. When you sell a call as an opening transaction, you're obligated to sell the underlying stock at the strike price, if you're assigned. When you sell a put as an opening transaction, you're obligated to buy the underlying stock, if assigned – it should be noted that short options are usually repurchased prior to expiration.
Describing Equity Options
An equity option is a contract which conveys to its holder the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) shares of the underlying security at a specified price (the strike price) on or before a given date (expiration day). After this given date, the option ceases to exist. The seller of an option is, in turn, obligated to sell (in the case of a call) or buy (in the case of a put) the shares to (or from) the buyer of the option at the specified price upon the buyer's request.
Equity option contracts usually represent 100 shares of the underlying stock. Strike prices (or exercise prices) are the stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. For example, as mentioned, each option contracts equates to 100 shares of stock. Therefore, two contracts at $2 per share equals $400 (2 contracts X's100 shares X's $2 per share).
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.
The Option 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.
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. For example, four contracts purchased at $1.50 per share equals a $600 premium (4 contracts X's100 shares X's $1.50 per share).
Option Expiration Day
The specific expiration date for each individual option depends on the type of option (i.e., monthly, weekly, quarterly, etc.) For example the expiration day for standard monthly options is the Saturday following the third Friday of each calendar month - therefore, the third Friday of the month is the last trading day for expiring standard monthly options. Non-standard bi-weekly and monthly options expire on the last business day of the month and stop trading at the close on that same day. Quarterly options expire on the last business day of each quarterly calendar month (March, June, September and December) and stop trading at the close on that day. Weekly options that expire on Saturday stop trading on Friday and weekly options that expire on Wednesday stop trading at the close on that day.
Long-Term Equity Anticipation Securities (LEAPS) are contracts with expiration dates of up to three years into the future. Equity LEAPS contracts expire on the third Friday of January in the expiration year. "Triple Witching" occurs on the third Fridays of March, June, September and December. This is when options, index futures and options on index futures expire concurrently.
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.
Disclaimer: Trading and investing involve a substantial degree of a risk of loss and are not suitable for everyone. Past performance is not indicative of future results. Fundamental factors, seasonal and weather trends, daily news, and other current events may have already been factored into the markets. Some trading strategies have unlimited risk. Educate yourself on the risks and rewards of such investing prior to trading. The publisher, and/or its affiliates, staff or anyone associated with www.theoptionplayer.com, do not guarantee profits or pre-determined loss points, and are not held monetarily responsible for the trading losses of others (subscribers or otherwise). Information provided is compiled by sources believed to be reliable. The publisher, and/or its principals, assume no responsibility for any errors or omissions as the information may not be complete or events may have been canceled or rescheduled. Any copy, reprint, broadcast or distribution of this report of any kind is prohibited without the expressed written consent of the publisher.