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Option Concepts

Terminology

Ask

The price you select when placing a Limit Order to sell a financial instrument such as a stock. The lowest ask is the price paid when placing a market order to buy. The Ask is also referred to as the Offer.

Bid

The price you select when placing a Limit Order to buy a financial instrument such as a stock. The highest bid is the price received when placing a market order to sell.

Index

An index is a group of companies and their stock prices are averaged by including each company's total number of shares in the calculation. Popular indices are: DJI (Dow Jones Industrial Average) which consists of 30 of the largest NYSE and NASDAQ stocks. S&P 500 (Standard and Poor's) which consists of 500 of the largest NYSE and NASDAQ stocks. NASDAQ Composite which includes all stocks listed on NASDAQ. The S&P 500 and the NASDAQ Composite are weighted which means that the larger companies contribute a greater proportion to the average calculation. So a stock ranked no.1 contributes more to the calculation than a stock ranked No.100.

Introduction to Stock Options

Understanding Stock Options - Introduction; picture of a stock options chart with price and contract conditions shown in an animated format

Stock options are popular with investors and traders alike. Options can be used for a variety of strategies ranging from hedging techniques to stock speculation through to options trading.

There are two types of options, a call option and a put option.

  • Call option is a contract which allows an investor or trader to buy stock at a specified price on or before a specified date.
  • Put option is a contract which allows an investor or trader to sell stock at a specified price on or before a specified date.

The holder of a call option has the right to buy the stock, but if the stock price is not favorable they are under no obligation to buy the stock.

Similarly, the holder of a put option has the right to sell stock, but if the stock price is not favorable they are under no obligation to sell their stock.

The option buyer is simply paying for the right to buy stock with a call option or paying for the right to sell their stock with a put option.

Stock options were developed in 1973 by the Chicago Board Options Exchange and are referred to as listed options since they are traded on an exchange. There are some similarities between listed options and stocks. Listed options are bought and sold on an exchange just like stocks with bids and asks. However listed options are not bought from NYSE or NASDAQ, but from a variety of options exchanges.

The largest range of listed options are stock options, but there are also listed options over indices such as the DOW and the S&P 500. These are referred to as index options.

In fact, options can be over any financial instrument such as commodities or currency but these option types are not the focus of this series which focuses specifically on stock options.

Investors can buy options over indices, currencies

and commodities – not just stocks

To avoid confusion, stock investors should be aware that there is a difference between listed options and company issued options. Companies will often issue options over their stock and issue these to their key employees as part of their remuneration package as an incentive to improve company profits. The idea is that if the key employees can increase company profits then the stock price will also increase making their options more valuable. These company issued options are call options but they are not the same as listed call options.

Within the stock market, listed options are simply referred to as options.

All options contracts are standardized contracts and state the following information.

Options contract information:

  • Call or Put: All options contracts state whether it is a call option or whether it is a put option.
  • Underlying: This is the company that the contract is over. For a call option, this is the stock that can be bought. For a put option, this is the stock that an investor can sell.
  • Strike: This is the price that the stock can be bought for with a call option or the price that the stock can be sold for with a put option.
  • Multiplier: This states how many shares the options contract includes. The majority of option contracts are for 100 shares. This means if an investor buys one call option, the investor can buy 100 shares.
  • Expiry date: All options contracts have a time limit that the contract is valid until. Once the expiry date has passed, the option contract is no longer valid.
  • Option style: This states whether the option is an American style option or a European style option. This denotes whether an option can be exercised at any time before expiry as with American options or if the option can only be exercised on the expiry date as with European options.

All options have an expiry date after which the option ceases to exist. This means that options have a time limit. The time left till expiry varies considerably with some options having less than one month and others having several years. Basically the longer the time till expiry then the more expensive the option is to buy.

Understanding Stock Options - Introduction; picture of a phone with stock options chart and data with price and contract conditions shown on the screen

When an investor buys a call option and then decides to buy the stock, the investor must pay the Strike price multiplied by the number of shares (usually 100). This process is known as "exercise" and terminates the option contract. Thus, once the investor buys the stock, a call option contract no longer exists and the investor can no longer sell their call option contract.

The same applies to a put option which is exercised. Once the investor sells their stock to the put option the contract is terminated.

Options can be bought from an options exchange and they can be sold on an options exchange up until the option expires. The investor does not receive a refund after the option expires if they have not sold or exercised their option by the expiry date. This is one of the risks with options, that it will expire worthless.

Most options issued in the U.S. are known as American style options. These options can be exercised at any time up to and including the expiry date. The other style of options is known as European style and these options can only be exercised on the expiry date and not before.

The price paid for an option is referred to as the option premium and is dependant on the Strike price of the option and on how long the option has left till expiry.

Typically most stock options have numerous Strike prices for both call options and put options. The number of strike prices is dependant on the popularity of options with a particular stock. Some stocks only have a couple of Strike prices while others can have well over 50 Strike price levels and some stocks have no options at all.

The list of Strike price levels is known as an options chain and a hypothetical example is shown below in Table 1.

Table 1. Options chain series

Introduction to Stock Options - Table showing stock Options chain series for put and call for different strike prices

From Table 1. above, the Last is the last price for the stock. To buy an option the investor pays the Ask price and has a choice of Strike prices.

When the Strike price for a call option is lower than the last price for the stock, then the option is said to be In-The-Money as the option could be immediately exercised and stock acquired for less than the current stock price. When the Strike price is above the last stock price for a call option, then the option is said to be Out-The-Money as it is currently more expensive to acquire stock by exercising the call option. The converse applies to put options, which are In-The-Money when the Strike price is above the stock price and Out-The-Money when the Strike price is below the stock price.

The Volume refers to the number of option contracts traded on the day. The Open Interest refers to how many contracts are currently held. Usually the options which are closer to the current stock price tend to be the more actively traded options. With the exception of some heavily traded stocks it is fairly common for options to only trade a couple of contracts a day and a lot of options can only have a few trades in a month and some options have no trades at all.

When buying an option with the intention of reselling the option, then the liquidity of the option should be considered. As a general rule the Bid-Ask spread tends to increase as the liquidity decreases.

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