Options

Basic Options Education

By definition, an option is a contract between two parties which gives the owner (holder) the right to buy or sell a specific amount of an underlying interest at a specified price and by a specified time.

Options Terminology

Call Options - Calls give the buyer the right to purchase (for a limited time) the specific quantity of the underlying interest. A call would be purchased if the investor expected a rise in the market value of the underlying interest in the future.

EX: Jan MSFT 25 CALL would give the buyer or holder of that option the right to buy 100 shares of Microsoft stock at $25 per share up until the January expiration of the option contract, which is the Saturday following the third Friday of the month. The buyer or holder is bullish and hopes the market value of the stock is above $25 at expiration to make a profit. So, if the stock is trading at $28 at expiration, the buyer of the call option can exercise his right to buy the 100 shares at $25 and then immediately sell them in the open market for $28 and gain a $3 per share profit or $300 on that option contract.

Put Options - Puts give the buyer of the option the right to sell (for a limited time) the underlying interest according to the terms of the contract. A put would be purchased if the investor expected a future decline in the value of the underlying interest.

EX: Jan MSFT 25 PUT would give the buyer or holder the right to sell 100 shares of Microsoft at $25 per share up until the January expiration. The buyer or holder is bearish and hopes the market value of the stock declines at expiration to make a profit. So, if the stock is trading at $22 at expiration, the buyer of the put can exercise his right to sell 100 shares of the stock and then buy it back in the open market for $22 and gain $3 per share or $300 for that option contract.

Option Buyer - The person purchasing the option contract, also referred to as "long". The premium the buyer pays allows him/her the right to purchase the underlying interest at a specified price, for a limited time. The buyer (or holder) is the only one who can exercise the option.

Option Writer - The person selling the contract to the buyer, also referred to as "short". The seller is obligated to fulfill the terms of the contract if the holder exercised his/her option. The writer would be the investor on the other side of the trade in the above examples. They collect a premium for selling or writing the option and hope that the market value of the underlying stock stays the same or goes in the opposite direction by expiration. This way, they keep the premium without having to fulfill any obligation.

EX: A option writer sells a Jan 25 MSFT CALL to a buyer for $4 premium. This means they are collecting $4 times the 100 shares that 1 contract represents or $400. At expiration, the stock is selling for $22 and did not go in favor of the buyer who wanted the underlying stock to go up. Now, it makes no sense to exercise and buy a stock for $25 when the same stock in the open market only costs $22. Thus, the option expires worthless, the option buyer loses 100% of his premium ($400) and the option writer keeps the $400 without any obligation. The same is true of a put writer if the stock has increased above the strike price at expiration.

Just to clarify which side of the market everyone is on:

Call Buyer (holder) Bullish (market value of the stock must increase above strike)

Call Writer (seller) Bearish (market value of the stock must decrease below strike)

Put Buyer (holder) Bearish (market value of the stock must decrease below strike)

Put Writer (seller) Bullish (market value of the stock must increase above strike)

Exercise Price - Also known as the strike price. This is the dollar amount or value at which the seller agrees to deliver the underlying interest to the buyer. Strike prices (for stock options) are generally set at 2 ½ point intervals between $5 and $25, then 5 point intervals above that.