Options can be very confusing for new traders however once you understand a few basics they are really quite straightforward.
There are 2 types of options to be considered.
A Call Option and a Put Option.
If you BUY an option it gives you certain rights. If you BUY a call option, it gives you the RIGHT to buy the instrument at a fixed price on a given date in the future IF you wish to. There is no OBLIGATION on you to proceed with the purchase in the future. If you BUY a put option, it gives you the RIGHT to sell the instrument at a fixed price on a given date in the future IF you wish to. As with the call option, you have the right but not the obligation.
Expiry Date: all options have an expiry date. This is the future date referred to in the paragraph above. For US equity options, as a general rule, the expiry date is on the third friday of the month (although there are some equities you can trade options on that expire every week and you can also trade an option several months out) The expiry date is specified when you trade the option.
Premium: when you BUY an option, you pay the seller (called the Writer) of that option a premium. If you are the writer, the buyer of the option will pay you the premium for that option.
Strike Price: this is the price at which you will buy or sell the instrument at expiry.
Lets consider an example.
Today is the 8th of May 2017 and this is an option chain for Apple for May17 Expiry. This means that the date these options will expire is on the 19th of May 2017 being the third Friday.
On the left hand side, you see the CALL options and on the right hand side the PUT options. Down the middle column you can see the STRIKE price of the option. You also see columns for the Bid and the Ask for both Calls and Puts. If I wanted to BUY the 152.50 CALL I would have to pay the ASK price of $1.75 per share. If I wanted to SELL the 152.50 CALL I would sell at the BID price of $1.73 In both cases I could place a LIMIT order and specify the price I am prepared to buy or sell at or I can just place a market order and I will get filled at the best price.
The difference between the bid and the ask price is called the spread. Highly liquid stocks have very tight spreads.
Note also that some of the lines are shaded yellow and some are white. The yellow shading indicates that the current price of the stock (which is $153.01) is greater than the call strike price or less than the put strike price. This is called as the option is ‘in-the-money’ (ITM).
Conversely, in the white section, the current price of the stock is less than the call strike price or more than the put strike price and the option is said to be ‘out-of-the-money’ (OTM).
Should the strike and stock price be near each other, the option is said to be ‘at-the-money’ (ATM.
So let’s say we want to buy a call on AAPL MAY17 expiry at 155 strike. We would pay $0.79 per share for this option. ($79 for 100 shares less brokerage and any regulatory fees. The minimum contract is 100 shares and contracts are traded for multiples of 100 shares) Come 19th May, if the share price is greater than 155, unless I issue my broker instructions to the contrary, my option will be ‘exercised’ and I will be ‘assigned’ the number of shares specified in the contract at the strike price and I must have the funds in my account to cover this cost plus brokerage and regulatory fees. If I was the contract writer I would be obligated to sell my shares to the person holding the contract at that price. If the share price is less than the strike price, the call will ‘expire’ worthless and as the option buyer I have lost the amount of premium I paid and the seller has that as a profit which he keeps.
For put options, say we wanted to buy a put on AAPL MAY17 expiry at 150 strike. We would pay the asking price of $0.82. Come 19th May, if the share price is less than 150, unless I issue my broker instructions to the contrary, my option will be exercised and I will have to sell the shares in the contract at the strike price. If I was the contract writer, I would have to sell shares to the taker at the strike price. If the share price is greater than the strike price, the put will expire worthless and as the option buyer I have lost any premium paid and the seller has made a profit which he keeps.
Note in some cases, the broker will automatically exercise your option without further instructions from you at expiry so if you do not want to be exercised, you must close out the position before the close of business on expiry day.
See also article on Covered Calls
Originally posted 2017-05-09 12:16:00.