An option is a contract between two parties which gives a right to the buyer and an obligation to the seller. For example, a call option gives the buyer the right to buy a security at a certain price if he chooses and the seller the obligation to sell it at that price if the buyer chooses. The terms of all option contracts are standardized by the Options Clearing Corporation (OCC) to allow them to be traded on an exchange. Options may be based on stock, indexes, foreign currencies, interest rates, or bonds.
The two type of option contracts are calls and puts. A buyer of a call has the right to buy a security at a certain price while the seller has an obligation to sell if the buyer chooses. A buyer of a put has a right to sell a security at a certain price to the seller of the put, who has an obligation to buy it if the buyer wants them to. A buyer of an option pays a premium to the seller in exchange for the sellers obligation. The seller of an option wants the contract to expire without the buyer exercising his rights. If this happens the seller gets to keep his premium without performing any obligation. The price where the buyer has the ability to exercise his rights to buy or sell is called the "strike price"
For example, John owns 100 shares of XYZ which is currently at 60 dollars a share. He sells a call to Lucy which says he will agree to sell the stock to Lucy if the price is above 70 dollars a share. Almost all options have 9 months before they expire. Lucy pays for example 3 dollars a share to John for the right to buy XYZ at 70 dollars a share. If the stock price of XYZ moves above 70 dollars a share, Lucy can force John to sell the stock to her at 70 dollars a share even if the current price is 80 dollars a share. John wants the price to never go above 70 so he won't lose money from the sale and will now have a profit due to the premium he charged, while Lucy wants the price to go up above that amount so she can buy the stock at a discount below the current market value.
A buyer of a call is called a "long call" while the seller is called a "short call". The same applies to puts. This terminology is not related to being "long or short" a stock, and should simply be memorized as long being option buyer and short being option seller.
Standard features of almost all options:
- Options last 9 months, and expire on the Saturday following the third Friday of the last month at 11:59 PM Eastern time.
- Options based on stock are based on 100 shares of a particular stock.
The standard format for describing an option contract is as follows:
Long XYZ Feb 50 call at 2
The word "long" refers to the fact that this is the buyer of an option contract. XYZ is the stock symbol for the shares the option is based on. Feb refers to the expiration month of the contract. 50 refers to the strike price of the contraact. Call specifies that it is a call, "at 2" shows the premium paid for the contract.
In the money, an option is in the money if the market price of the security exceeds (in the case of calls), or is below (in the case of puts) the strike price. A buyer is able to exercise his rights when an option is in the money. Buyers want options to be in the money, sellers do not want this.
At the money, an option is at the money where the market price equals the strike price.
Finally, Out of the money is when the price of an optioned security is below (in the case of calls) or above (in the case of puts) the strike price.
Intrinsic Value is a somewhat confusing term. The intrinsic value is calculated based on the premium and takes into consideration the time value and/or volatility of the underlying security. It is calculated by examining the premium paid and subtracting the difference of the security in the money less the strike price less the option price, hence, if there is a value left over, this is considered the intrinsic value. It does not take into consideration the premium paid.
Straddle - Is when the investor is long a call and long a put or short a call and short a put in the same underlying security. The perceived thinking in entering into a straddle is based on volatility.
The buyer of the straddle is betting that the underlying security will move in large percentages within the expiration date of the options. The seller is betting that the security will not be volatile and aims to make a profit off of the premiums received from selling(shorting,writng) the option contracts.