Options Basics Explained

There are two kinds of options, both traded publicly on the open exchanges. First is the call, which is an intangible contract giving its owner the right, but not the obligation, to buy 100 shares of stock at a fixed price. Second is the put, which is the opposite. The put gives its owner the right, but not the obligation, to sell 100 shares of stock at a fixed price.

Every option has a specific and fixed price called the strike. This is the price at which the owner of a call is allowed to buy 100 shares even if the current market price is much higher; or the price at which the owner of a put is allowed to sell 100 shares even if the current market price is much lower.

In addition to a fixed and unchanging strike price, every option is also tied to a specific expiration date. That is the date when the option will become worthless.
It is the Saturday immediately after the third Friday of the specified expiration month.

The final unchanging attribute of every option is the underlying security on which it is traded. This can be a stock, an ETF, or a commodity. Most people starting out in the market are likely to begin with options on stock. The underlying security is fixed and cannot be transferred or replaced.

Collectively, these attributes of options -- type of option (call or put), strike, expiration date, and underlying security -- are referred to as an option's terms. These terms are fixed and unchanging, and while many options are likely to be available at any time, each one is defined by the terms.

Key Point

Every option's terms are fi xed and cannot be changed; this ensures an orderly market for trading in option contracts.

There are several possible outcomes for both buyers and sellers of options. In each case, you can buy an option that grants you the rights spelled out by the terms. If you sell an option, you give up those rights, meaning someone else could exercise the option. If you sell a call and it is exercised, 100 shares of the underlying stock are called away and you are required to deliver those shares at the strike price. If you sell a put and it is exercised, 100 shares of the underlying stock are put to you at the strike price.

A seller of either option faces the risk of exercise. A call will be exercised only when the current price per share is higher than the strike; and a put will be exercised only when the current price per share is lower than the strike. For the owner of either option, the strike is fixed so an advantage to exercise is in the ability to buy 100 shares below current value (exercising a call), or to sell 100 shares above current value (exercising a put).
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

Posted in ...