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A Guide to Understanding Options and Their Features

By: , dated January 25th, 2013

Options are a type of derivative, which simply means that their value depends on the value of an underlying investment. In most cases, the underlying investment is a stock, but it can also be an index, a currency, a commodity, or any number of other securities.

A stock option is a contract that guarantees the investor who has purchased it the right, but not the obligation, to buy or sell 100 shares of the underlying stock at a fixed price prior to a certain date. Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. In the case of a security that cannot be delivered such as an index, the contract is settled in cash.

There are two basic forms of options. A call option provides the holder with the right to buy 100 shares of the underlying stock at the strike price, and a put option provides the holder with the right to sell 100 shares of the underlying stock at the strike price. If the price of a stock is going to rise, a call option allows the holder to buy stock at the price before the increase occurs. Similarly, if the price of a stock is falling, a put option allows the holder to sell at the earlier, higher price.

For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. The upside, however, is unlimited. Options, like stocks, are therefore said to have an asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security underlying the option.

Options are most frequently used by individual investors as either leverage or insurance. As leverage, options allow the holder to control equity in a limited capacity without paying the full price of buying shares up front. The difference can be invested elsewhere until the option is exercised. As insurance, options can protect against price fluctuations in the near term because they provide the right acquire the underlying stock at a fixed price for a limited time.

Stock options also form the basis for more complicated trading strategies that will be discussed only briefly here.

It is important to remember that options can be an extremely risky investment, and they are certainly not appropriate for beginning investors. Only the most experienced investors should include options in their investment strategy, and even the most knowledgeable investors should prepare for the possibility of substantial losses. Information about options trading can be acquired from the Chicago Board Options Exchange (1-800-OPTIONS).

Advantages and Disadvantages of Options

Advantages:

  • An investor can gain leverage in a stock without committing to a trade.
  • Option premiums are significantly cheaper on a per-share basis than the full price of the underlying stock.
  • Risk is limited to the option premium (except when writing options for a security that is not already owned).
  • Options allow investors to protect their positions against price fluctuations.

Disadvantages:

  • The costs of trading options (including both commissions and the bid/ask spread) is significantly higher on a percentage basis than trading the underlying stock, and these costs can drastically eat into any profits.
  • Options are verycomplex and require a great deal of observation and maintenance.
  • The time-sensitive nature of options leads to the result that most options expire worthless . Making money by trading options is extremely difficult, and the average investor will fail.
  • Some option positions, such as writing uncovered options, are accompanied by unlimited risk.

Option Components

An option for a given stock has three main components: an expiration date, a strike price and a premium. The expiration date tells the month in which the option will expire. Options expire one day after the third Friday of the expiration month. The strike price is the price at which the holder is allowed to buy or sell the underlying stock at a later date. The premium is amount that the holder must pay for the right to exercise the option. Because the holder acquires the right to trade 100 shares, the total cost of the option, if exercised, is 100 times the premium.

In order to relate them to the price of the underlying stock at any given time, options are classified as in-the-money, out-of-the-money or at-the-money. A call option is in-the-money when the stock price is above the strike price and out-of-the-money when the stock price is below the strike price. For put options, the reverse is true. When the stock price and strike price are equal, both types of options are considered at-the-money.

Of course, when calculating profit and loss, the premium, as well as taxes and commissions must be factored in. Therefore, an option must be far enough in-the-money to cover these costs in order to be profitable.

Valuing and Pricing Options

The price of an option is primarily affected by:

  • The difference between the stock price and the strike price
  • The time remaining for the option to be exercised
  • The volatility of the underlying stock

Affecting the premium to a lesser degree are factors such as interest rates, market conditions, and the dividend rate of the underlying stock.

Because the value of an option decreases as its expiration date approaches and becomes worthless after that date, options are considered “wasting assets”. The total value consists of intrinsic value, which is simply how far in-the-money an option is, and time value, which is the difference between the price paid and the intrinsic value. Understandably, time value approaches zero as the expiration date nears. The Black-Scholes model, based on wave equations from physics, is used to calculate the theoretical value of options. The formula reveals the time value remaining in an option and take into account the pricing factors listed above. Over time, option prices approach their theoretical values.

In general, premiums should increase as the volatility of the underlying stock increases because the greater fluctuation makes the right to buy in the future at the current price more valuable. Volatility can be historical or implied. Historical volatility is based on the past performance of the stock. Implied volatility is a reflection of the way options are being priced in general.

Exercising Options

Exercising an option consists of buying (in the case of a call option) or selling (in the case of a put option) 100 shares of the underlying stock at the strike price. Options are classified as American or European depending on the way in which the holder may exercise them. The holder may exercise an American style option at any point between the time of purchase and the expiration date. A European style option, on the other hand, cannot be exercised until expiration. Most stock options are American style, but some index options are European style.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

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