Stock options are powerful and complex financial instruments, but that doesn't mean they have to be complicated to understand. The most important feature to grasp is that options are derivatives, meaning that they are derived from other existing investment products. The underlying commodity for a stock option is stock, which is itself a type of security granting a share of ownership in the company that issued it.
Options contracts are created instruments, meaning that a speculator has written the contract into existence. This speculator is referred to as the “writer,” and in return for creating the option, the writer receives a payment, known as the premium, from an investor who purchases it from her. The premium is the reason the writer has created the option, and it's how she earns a profit. An option buyer's risk is limited to cost of the premium.
Exercise and Expiration
Option contracts obligate the writer while simultaneously granting a right to the purchasing investor. In the case of stock options, the writer is obligated to somehow trade 100 shares of the underlying stock. However, both the writer's obligation and investor's right are time-limited, as each contract is written with an expiration date. Until that date arrives, the option's owner may exercise his right and force the writer to fulfill her obligation, according to the details of the contract. Time value therefore plays a critical role in determining the premium, which becomes zero whenever an option expires.
Call and Put Options
When a writer creates an option, she obligates herself to either buy or sell the underlying commodity. Options that obligate her to sell the commodity are call options. Call options are created by writers who are generally bearish about the commodity. Alternatively, options that obligate the writer to buy the commodity are put options. Put options are created by writers who are generally bullish about the commodity.
The strike price, also known as the exercise price, is the amount at which the writer is obligated to buy or sell the commodity should the contract be exercised. For example, a call option for XYZ Corporation with a strike price of $25 obligates the writer to sell 100 shares of XYZ at $25 per share. If the share price of XYZ is ever less than $25, the option is considered “out of the money,” and if the share price is ever higher than $25, the option is “in the money.” As with time value, the consideration of an option's strike price to the underlying stock's current share price plays an important role in determining the premium.
- Options for the Stock Investor: How to Use Options to Enhance and Protect Returns; James B. Bittman
A Florida native, Doug Wetzel has a background in both finance and technology ranging from investment banking to CTO and director of research and development for a NASDAQ company. Since 1994, Wetzel has also been a technical writer, authoring white papers such as DCTI's "Credit Card Fraud," and Web articles for AnswerBag and eHow.