WHAT IS AN OPTIONS CONTRACT?
Much like any contract, an options contract represents an agreement between two parties. In this case, the agreement gives the BUYER of the contract the “OPTION” to buy or sell a specific asset at a predetermined price (Strike Price) before a specified expiration date. Options are a form of derivatives.. In the case of stock options, the contract is a derivative of the underlying stock.
Click here to learn more about derivatives.Buyer: The buyer is paying a Premium for a contract that gives them the right (not the obligation) to buy or sell an asset.
OPTION: The buyer is not required to buy or sell the asset, they simply purchased the right (or option) to buy (if a call) or sell (if a put) the asset at the predetermined price by the expiration date. They bought the ability to have that choice.
Let’s expand further:In most cases, stock option contracts will represent 100 shares of the underlying equity. So the contract represents the right to buy or sell 100 shares of the stock at the strike price by the expiration date. Contracts premiums are quoted per share and since most contracts represent 100 shares, you must multiply the quoted price by 100. For Example: If a contract is quoted at 25 cents, buying one contract would cost $25.
There are two key types of options contracts when talking about stock related options. The two types of option contracts are Calls or Puts.
What are Calls?:
An option contract that gives the buyer the right to PURCHASE shares of the underlying at a set price by a specified expiration date.
What are Puts?:
An option contract that gives the buyer the right to SELL shares of the underlying at a set price by a specified expiration date.
What is “In the Money” (ITM)?:
- In the money refers to an option that’s strike price has been exceeded. If the contract(s) were Calls, the stock would need to be trading above the strike price to be considered ITM. If the contract(s) were Puts, the stock price would need to be trading below the strike price to be considered ITM.
- When an option contract is In The Money, it has intrinsic value. Remember, the contract represents 100 shares, so for every dollar that a contract goes ITM, it will have an intrinsic value of $1X100=$100.
- When a Call is ITM, it means the buyer can PURCHASE the shares BELOW it’s current price.
- When a Put is ITM, it means the buyer can SELL the shares ABOVE it’s current price.
What is “Out The Money” (OTM)?
Out the money refers to an option that’s strike price has NOT been reached or exceeded. If the contract(s) were Calls, the stock would be trading BELOW the strike price to be considered OTM. If the contract(s) were Puts, the stock price would be trading ABOVE the strike price to be considered OTM.
When an option contract is Out The Money, it has no intrinsic value. The contract’s current value is strictly based on it’s extrinsic value (the likeliness that the contracts will go ITM before expiring).
Unlike shares of stocks, Option contracts have expiration dates. Once it has passed a contract’s expiration date, the contract no longer exists and can no longer be traded. It is very unlikely that a company’s stock will go to $0.00, but with options it is not uncommon. Let’s talk about why!
There are many factors that go into the pricing of options. The best way to think about it is, the more likely the contract is to go ITM, the higher the premium will be.
What is Moneyness?:
- When the underlying asset’s value is closer to the Strike Price or Exceeds the strike price, the value of the contract will be higher.
- The further from the money or the underlying asset's price is, the lower the contract's premium will be.
How does Time Impact Option Premiums?:
- The longer a contract has until expiration, the higher the value. (Increased time = increased possibility of the contract going ITM). The expression "time is money" is very true in the world of options.
How Does Volatility Impact Option Premiums?:
- When there is an expected event or earnings report coming up that can result in a large move (in either direction), you will notice contract prices increase leading up to the event due to implied volatility.
What is “Intrinsic Value”?
Intrinsic value only applies to ITM options because the value is based on how far ITM the contract goes. As mentioned above, each contract will typically represent 100 shares, so if the shares go ITM by $1.00, the contract would have a minimum value of $1.00 X 100 shares. That is the intrinsic value and the minimum value that an ITM option can be valued at.
There are MANY different ways to trade options, but we are going to stick to the 2 primary ways to open an option position.
- Buying to Open an option position. This can be known as a long.
- When a CALL is bought to open, it is considered a long call which means the buyer of the position believes the value of the underlying asset will increase (Bullish Sentiment). When the underlying asset price rises, it can create unlimited upside potential, but limits the downside to the premium paid for the position.
- When a PUT is bought to open, it is considered a long put which means the buyer of the position believes the value of the underlying asset will decrease (Bearish Sentiment). When the underlying asset price decreases, it can create unlimited upside potential, but limits the downside to the premium paid for the position.
Reminder: In most cases, a contract represents 100 shares and the increased premium of the contracts will often coincide with the increased value (if calls) or decreased value (if puts) of the 100 shares they represent. This is especially true once a contract has gone ITM.
2.Selling to Open an option position. (Also known as a “short”)
- When a CALL is SOLD to open, it is considered a short call which means the seller of the position believes the value of the underlying asset will either decrease or just doesn’t believe it will increase (Bearish Sentiment). When you sell to open, you collect a premium for the contracts that were sold. The premium collected is the maximum gain to be achieved from the position. If the underlying assets price goes down, the contracts lose value and can be bought back to close the position at the lower price (or $0 if the contracts expire OTM). When the underlying asset price decreases, it can create unlimited downside potential (if the contracts were sold naked), because the value of the contract has no limit on how high it can go and could result in the seller needing to either buy the contracts back at the higher price or purchase the shares required to sell to the call holder (100 shares per contract).
- When a PUT is SOLD to open, it is considered a short put which means the seller of the position believes the value of the underlying asset will increase or just doesn’t believe it will decrease (Bullish Sentiment). When you sell to open, you collect a premium for the contracts that were sold. The premium collected is the maximum gain to be achieved from the position. If the underlying assets price goes up, the contracts lose value and can be bought back to close the position at the lower price (or $0 if the contracts expire OTM). When the underlying asset price increases, it can create unlimited downside potential (if the contracts were sold naked), because the value of the contract has no limit on how high it can go and could result in the seller needing to either buy the contracts back at the higher price or purchase the shares required to sell to the call holder (100 shares per contract).
Trading in options involves considerable risk and is not a suitable form of investment for all investors. The risk in options trading that you will lose your entire investment within a relatively short period of time is comparatively high. It is possible that the loss and the resulting payment obligation will be higher than the funds invested through your securities account. Therefore, please be sure to check in advance on your trading broker’s terms and conditions of those of the custodian bank. Before you decide to invest in the options market, you should carefully consider your investment objectives, experience, financial resources and willingness to take risks. There is a possibility that you will experience a significant loss that can quickly exceed your initial investment.
