Many stock traders have heard of options but do not really understand them. Others assume they are complex and high-risk. This does not always have to be true, as many forms of options are conservative and straightforward.
A major hurdle to developing a working knowledge of options is terminology. The options industry is full of exotic terms and phrases; this not only confuses outsiders but discourages them. So here is an attempt to explain the basics, if only to provide a starting point.
An option has no tangible value; it’s a contract that grants its owner specific rights. Every option has four standardized terms that distinguish one option from another. These cannot be transferred or changed. They are:
• Underlying security (or asset): All options are written on a specific underlying security (a stock, index, ETF or futures contract). This can never be changed. So as part of identifying an option, the underlying security also has to be defined.
• Type of option: There are two types of options. A call grants its owner the right—but not the obligation—to buy the underlying asset (100 shares of stock in the case of a security). A put grants its owner the right—but not the obligation—to sell the underlying asset or security.
• Expiration date: All options expire on a specific date. For monthly equity options, that is the third Saturday of the expiration month. The last trading day is the third Friday. After an option’s expiration, it ceases to exist and becomes worthless.
• Strike price: The strike price is the fixed price at which exercise will occur. So, an option with a strike at 25 will be exercised at $25 per share.
To properly describe an option, you need to clarify all four of these terms. “An option’s components” (below) shows a listing with all terms spelled out: the underlying McDonald’s (MCD), expiration month, day and year, strike price and type of option (in this case, a call).
The option is highly leveraged, averaging between 3% and 5% of the price of 100 shares of the underlying stock. But because it will expire by a specified date, the value of the option (known as its premium) tends to decline as expiration gets closer. An option buyer can never lose more money than the cost of the option, so risk is limited to the value at the time of purchase.
Options can also be sold. A seller grants all of the rights of exercise to a buyer, including the risk that an option can be exercised. In that case, option sellers will have 100 shares called away (through selling a call) or will have 100 shares put to them (by selling a put).
It is important to keep in mind the following points about options:
1. The rights granted through an option to buy or sell, are never infinite. Expiration is a fact of life in options trading.
2. Terms can never be exchanged with other terms; they are fixed and permanent.
3. The most common form of listed option applies to 100 shares of stock.
An easy method to keep different options and positions in mind is to check the following four-part list describing the four possible simple types of trades, which are as follows:
1. Buy a call (buy the right to buy 100 shares).
2. Sell a call (sell to someone else the right to buy 100 shares from you).
3. Buy a put (buy the right to sell 100 shares).
4. Sell a put (sell to someone else the right to sell 100 shares to you).
Directional ideas also define whether to buy or sell, and whether to use calls or puts. “Matching trades” (next page) summarizes how this works.