What is an Option?
To really get the most out of this educational experience, we need to start at the very basic building blocks. The first question that we need to answer is what exactly is an option.
An American Option is a financial contract that gives the owner the right, but not the obligation to buy or sell a security on or before a specified date (the expiration date) for a specified price (the strike price).
There’s a lot there, so let’s break it down in pieces.
- The security (also referred to as the “underlying”) – most exchange-listed equities have options associated with them. Many futures contracts listed on the futures exchanges have options associated with them. When you decide to trade an option, you first must choose the security that you are looking to trade.
- The expiration date – this is an exchange defined parameter for options. For equities, there are weekly expirations for many products that expire each Friday. There are also serial options that expire the 3rd Friday of each month. And for some products that have quarterly expirations expiring on the final business day of each quarter. Other products such as indexes and futures have varying expiration schedules that can be found on the exchange websites. The key here is to know that options are like term life insurance – they have an expiration date.
- The strike price – this is also defined by the exchange. Many equities have strikes that are as tight as $0.50 increments, and many are $5 increments. This is crucial to keep in mind. If a stock is trading $20, then we may find that the $25 call and $30 call expiring in 3 months are very different options while the $25.00 call and $25.50 call expiring in 3 months are very similar options – we will get into this and why it matters in later discussions.
Before I get into the process of exercising the option, we need to differentiate between a call and a put. The owner of a call has the option to buy the stock. The owner of a put has the option to sell the stock. The person who is short the call or put does not have any choice – if the trader who is long a call exercises it, a person who is short will be assigned. If a trader is assigned on a short call, he is obligated to sell the stock for the strike price. For a put, the trader who is short and assigned will be obligated to buy the stock for the strike price.
- Exercising the option – I will discuss this in terms of a call position, but similar logic can be applied to a put as a bearish bet. If you are long a call and elect to exercise the call, you are exercising your right to buy stock at the strike price. If the call is American, you can do this on any day up to the expiration date. European options can only be exercised on the expiration date, but most options contracts you will come across are American-style. If the underlying price is above your call strike at expiration, the call will automatically be exercised unless you have insufficient funds in your account. Be careful about this – it can be a costly mistake to hold long options to expiration in a small trading account so you should contact your brokerage firm to determine how they would handle exercising an option whether you have sufficient funds to buy the stock or not. If your long call strike is greater than the stock price on expiration, it will automatically be abandoned at expiration. Remember, you do not have to exercise the option.
So how does this differ from a stock position? If you are long a call and the price of the stock falls, you are not obligated to buy the stock. You will lose the premium paid for your call, but you cannot lose any more than this. This is the key to a call position – it can create many benefits for a trader as long as the price paid is reasonable. And yes, the price matters. We will get into what a reasonable price to pay is over time, but right now, the key is to understand what the option contract is before you enter into that transaction.