Options Fundamentals
Option Components
Options have five main standardised terms by which they are defined:
- Type of option (call or put)
- Underlying security (specific stock or index)
- Exercise (or strike) price
- Expiry date
- Option premium
These five variables distinguish each individual option from every other available option. Each time you enter a trade using options, these five terms define the parameters of your trade. It is essential to understand how these factors affect the nature of each trade in order maximise your chances of success.
Option Types
As we have already discussed, there are two types of options: calls and puts. A call option gives the buyer the right to buy a fixed number of shares of an underlying stock at the specified strike price on or before the option expiry date. The call buyer hopes the price of the underlying stock will rise prior to the call expiry date. The call seller (or writer) hopes that the price of the underlying stock will decline or remain below the call strike price until expiry.
A put option gives the buyer the right to sell a fixed number of shares of an underlying stock at the specified strike price on or before the option expiry date. The put option buyer hopes the price of the underlying stock will drop prior to the put expiry date. The put seller (or writer) hopes that the price of the underlying stock will rise or remain above the put strike price until expiry.
Underlying Security
Typically, each stock option contract provides the right to buy or sell 100 shares of the underlying security. This means 1 option contract represents 100 underlying shares. This may change slightly if there is an adjustment or a reorganisation of capital in the underlying stock. Not all stocks have options. If options are available, they can be bought and sold at a fraction of the cost of the underlying stock. Thus, options provide a high leverage approach that, in many instances, can reap large rewards from minimum risk trades in comparison to traditional buy and hold share investing.
Exercise or Strike Price
The exercise (or strike) price is the predetermined fixed price at which the underlying stock can be purchased (call) or sold (put). Options are available in standardised strike prices at standard intervals. Stocks priced under $2.00 have strike prices at 10 cent intervals. Stocks priced between $2.00 and $10.00 have strike prices at 25 cent intervals and stocks priced above $10.00 have strike prices at 50 cent intervals.
Expiry Date
Option expiry dates designate the last day on which an option may be exercised. The actual expiry date for stock (equity) options is usually the Thursday before the last business Friday of the expiry month although this can vary with public holidays and other events. After an option expires, the option buyer loses the right to buy or sell the underlying instrument at the strike price and all the obligations of the option become null and void and the option contract becomes worthless.
Option Styles
There are two styles of options: American and European. American style options can be exercised anytime up to and including the expiry day. Most options traded in the options market are American style. European style options can only be exercised on expiry day. Typically most Index options are European style.
Option Cycles
In general, all options for a particular class follow one of the three quarterly cycles that usually extend out nine to twelve months. The three cycles are listed below.
- Cycle 1: January / April / July / October
- Cycle 2: February / May / August / November
- Cycle 3: March / June / September / December
Options are usually listed for the current month and the next three months in the quarterly expiry cycle.
Option Premiums
The premium (or price of the option) is the compensation paid by the option buyer to the option seller (or option writer). Option premiums can vary as:
- They near expiry (time value shrinks).
- The price of the underlying security changes.
- Volatility fluctuates.
The actual change of the premium in comparison to the change in the price of the underlying stock is measured by the Greek called “delta.”
The potential loss on a purchased (long) option is limited to the premium paid, regardless of the underlying stock’s price movement. That’s why the purchase of an option enables traders to control the amount of risk assumed.
In contrast, the potential profit on a short (sold) option is limited to premium received, regardless of the underlying stock’s performance.
Call Options
A call option gives the buyer the right, but not the obligation, to buy a fixed number of shares (typically 100) of an underlying stock at a specific exercise price on or before the option’s expiry date.
Call Option Examples:
- XYZ Bank (XYZ) shares have a last sale price of $26.90.
- An available standard call option contract would be a XYZ December 27.00 call.
- A buyer of this contract has the right—but not the obligation—to buy 100 XYZ shares for $27.00 per share at any time on or before the expiry date in December.
- For this right, the buyer pays a premium (the purchase price) to the writer (seller) of the option.
- In order to take up this right to buy the XYZ shares at the specified price, the buyer must exercise the option on or before the expiry day in December.
- On the other hand, the writer of this call option is obliged to deliver 100 XYZ shares at $27.00 per share if the buyer exercises the option.
- For accepting this obligation, the writer receives and keeps the option premium regardless of whether the option is exercised or not.
- If the call option is exercised, the shares are traded at the specified exercise (strike) price.
- The last date when an option can be exercised is called the expiry date.
Put Options
A put option gives the buyer the right, but not the obligation, to sell a fixed number of shares (typically 100) of an underlying stock at a specific exercise price on or before the option’s expiry date.
Put Option Examples:
- Assume ABC (ABC) shares have a last sale price of $16.50.
- An available standard put option contract would be a ABC September 16.00 put.
- This gives the buyer (taker) the right—but not the obligation—to sell 100 ABC shares for $16.00 per share at any time on or before the September expiry day.
- For this right, the buyer pays a premium (the purchase price) to the writer of the put option.
- In order to take up this right to sell the ABC shares at the specified price the buyer must exercise the option on or before the expiry date in September.
- The writer of the put option is obliged to buy the ABC shares for $16.00 per share if the option is exercised.
- The same as with call options, the writer of a put option receives and keeps the option premium whether the option is exercised or not.
- If the put option is exercised, the shares are traded at the specified exercise (strike) price.
- The last date when an option can be exercised is called the expiry date.
