Options

Options Trading

What is an Option?

OptionsHouseAn option is a security where the buyer has the right but not the obligation to buy or sell as specific security on or before a certain date.    An option derives its value from underlying securities such as stocks, ETFs, bonds, commodities, currencies, and a plethora of alternative securities.

The term “the right but not the obligation” means that an investor can purchase or sell a security, but does not have too if the price of the security, when the option expires, is disadvantageous and not profitable.

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Type of Options

A call option is the right to purchase a security at as specific price on or before a certain date.  The price which the call option owner can purchase the underlying security is called the strike price. Strike prices are generally set by the exchange which clears options transactions.   They are generally in even increments such as $1 or $5 dollars. The date when the option expires is called the maturity date.

The maturity date of an option can vary.  Many regulated exchanges offer standard contracts with maturity dates that are weekly or monthly.  There are some that offer long term maturity dates and these options are known as leaps.

Options that can only be exercised on the expiration date which are called European style options, whereas options that allow an investor to exercise an option prior to the expiration date is referred to as an American style options.  The exercise of an option is the process of exchanging the option for the underlying security.  For a European style option, the purchaser can sell the option prior to expiration but cannot exercise the option prior to expiration.

A put option is the right to sell a security at a specific price on or before a certain date.  The strike price and the maturity date are used in the same way as a call option.

Options are used as speculative instruments as well as, products that can hedge the exposure of a portfolio.  Options trade on a plethora of regulated exchanges such as the Chicago Board of Option Exchange during normal trading hours.

The Value of an Option

The seller of an option receives a premium which is equivalent to the sale price of an option in return for giving the buyer of the option the right to purchase or sell a security.

When the underlying price of a security is below the strike price of a call option, the call option is said to be “out of the money”.  When the underlying price of a stock is above the strike price of a call option the option is said to be “in the money”.  When the underlying price of a stock is the same price of the strike price that option it is referred to as “at the money”.

The value of an option is comprised of intrinsic value, which is the amount by which the option is in the money.  For example, a call option with a strike price of $400 that expires in 60 days, when Apple stock is trading at $500, has an intrinsic value of $100 dollars.  If the price of the option is $110, then $10 dollars of the value is due to extrinsic value which is also known at time value.  If an option is out of the money or at the money, the entire value of the option is made up of extrinsic  or time value.

Why Exercise an Option?

An investor could consider exercising an option as opposed to selling the option if the value of the option is worth the same amount as the intrinsic value but the bid-offer spread makes selling the option less profitable.  The bid-offer is the difference between the price at which a market maker will purchase an options and the price at which a market maker will sell an option.

For example, say an investor purchased a call option on Facebook when the price was $20 per share.  With Facebook at $45 dollar a share, the option has an intrinsic value of $25 per share.  If the option bid price only reflects a small amount of time value say $45.01, but the brokerage cost for trading the option is $0.03 per share, then an investor might consider exercising the option and avoid the commission of selling the option.

Option Contracts

Options that trade on regulated exchanges, trade as option contracts.  An option contact controls 100 shares of an underlying stock. For example, if an investor exercised 1 contract worth of a Google option, they would own 100 shares of Google stock.  If the price of the Google option was $3 per share, not only would the investor need to pay the premium, but if they exercised the option they would need to pay for the shares.  Securities such as options on futures have different contract values, as each product is unique.

Option Prices

The value of an option is determined by market participants who trade options similar to the way stocks are traded.  The value of an option will fluctuate throughout the trading session based on a number of variables which include the price of the underlying security as well as the implied volatility of the option. The implied volatility of an options is the markets estimate of how much a security will move over the course of a year.

Option prices fluctuate based on supply and demand for both the underlying security and the protection value of an option.  As a generally rule of thumb, as the price of the underlying stock moves higher, the price of a call option moves higher.  The price of an option is affected by the underlying price to a greater extent when the option is in the money and to a lesser extent when the option is out of the money.

Changes in Option Values

There are numerous inputs that are used to create a theoretical value of an option.  Although the prices of option are driven by market participants, the use an option pricing model which help to determine the approximate value of an option.  The value is mainly based on the chance that an option will be in the money by the expiration date.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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