While options may seem mysterious to most investors at first, the basics are actually quite simple to understand.
Options are simply legal contracts between two people to buy and sell stock for a fixed price over a given time period.
These contracts are standardized, meaning they control a fixed amount of shares and expire at the same time. Because of this standardization, they are traded on an exchange, just like shares of stock. The contracts are usually highly liquid, which means there are many buyers and sellers standing by who are willing to buy or sell. You can buy an option contract with the same speed it takes you to call your broker and buy stock.
There are two types of options: calls and puts.
A call option gives the owner the right, but not the obligation, to buy stock ("call" it away from the owner) at a specified price over a given time period.
In trading lingo, any asset that you buy is called a longposition. If you buy a call option, you are the owner, and are long the contract. Notice that the owner, the long position, has the right, but not the obligation, to buy stock. You are allowed to purchase the stock for a fixed price, but are not required to do so. In other words, you have the option to buy -- which is where these financial assets get their name.
The price at which you can buy the stock is called the strike price, which is kind of a slang term that came into use, because that's the price where the deal -- the contract -- was struck. Generally, each contract controls 100 shares of stock, called the underlying stock, which we will talk more about later. For now, just understand that unless otherwise stated, each contract controls 100 shares.
Each contract is good only for a certain amount of time. Usually you can find contracts with as little as a couple of weeks and as long as three years of time remaining. However, these are standardized time frames, so you don't get to pick the exact date you want it to expire.
Just as stock is traded in shares, options are traded in units called contractsSee Trading Units contracts.
If you buy one IBM March $100 call option (one contract), you have the right, but not the obligation to buy 100 shares of IBM (the underlying stock) for $100 per share (the strike price) through the expiration date in March, which is usually the third Friday of the month[1].
If you think about the definition of a call option, you have probably encountered similar agreements outside the financial markets. Your local pizza place may have a coupon good for the next 30 days that allows you to buy a large pizza for $10. That's similar to a call option. It's like a contract locking in your purchase price over a fixed time period. After that time period, the option to buy at that price expires. While the pizza shop may make an exception and allow you to use the coupon after the expiration date, there is no such thing with a call option. Once it's expired, it's gone.
Think of a call option as a coupon giving you the right to buy stock at a fixed price through an expiration date. The big difference between a coupon and a call option is that you must pay for the option while coupons are generally handed out for free.
A put option allows the owner to sell their stock ("put" it back to someone else) for the strike price within a given time. As with call options, the put buyer (long position) has the right, but not the obligation. If you buy an IBM March $100 put, you have the right, but not the obligation, to sell 100 shares of IBM for $100 per share through the third Friday in March.
Buying a put option is similar to buying an auto insurance policy. You can buy a policy for a premium and collect the insurance value if you wreck your car. If you don't wreck your car, you are only out the amount of the premium. Likewise, you can buy a put option for a premium and turn it back to the insurer (the put seller) if your stock should crash (fall below the strike price). If the stock stays above the strike, you would let the "insurance" expire and lose only the premium you paid.
Notice that with either calls or puts the buyers (the "long positions) have the right, but not the obligation, to buy or sell. The investor on the other side (the seller of the option, also called the "short position) has the obligation to fulfill the contract; he or she has no choice. If a long call owner decides to buy the stock, the short call trader must oblige and sell. Likewise, if long put owners decide to sell their stock, the short put traders must purchase the stock. Regardless of whether the short option seller is forced to buy or sell stock, the premiumreceived from the initial short trade is theirs to keep. That's their compensation for accepting the risk.
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Call Option |
Put Option |
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Long position |
Right, but not the obligation, to buy stock at the strike price |
Right, but not the obligation, to sell stock at the strike price |
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Short position |
Possible obligation to sell stock at the strike price |
Possible obligation to buy stock at the strike price |
Many new traders to options may be concerned that the short side will not deliver. In other words, if you want to use your option to either buy or sell shares, is there a risk of the short seller refusing?
There is no need to worry about contract performance from the short seller. In other words, if you decide you want to purchase 100 shares of IBM at $100 with your call option, there is no need to worry about the seller of the call (the short call position) not delivering the shares. This is because an intermediary called the Options Clearing Corporation (OCC is really the buyer to every seller and the seller to every buyer. The OCC is well capitalized and does not run the risk of default. Because of this, investors do not even need to know who is on the other side of the trade, as the OCC guarantees contract performance. Ever since the inception of the OCC in 1973, no investor has ever lost money due to default by the other party. Keep in mind this does not mean the OCC guarantees contract profitability but only that you are guaranteed to buy or sell shares with your long option position if you decide to do so.
The function of the OCC is to provide investor confidence, thereby providing better prices and liquidity .
If you wish to buy stock with your call option or sell stock with your put option, you simply call your broker and tell them you want to exercise the option. Three business days later, the transaction will take place. For example, if you own a $50 call option and decide to exercise it, your account will be debited for $5,000 ($50 per share times 100 shares per contract) plus commissions and credited 100 shares of stock on the third business day. Similarly, if you own a $50 put and exercise it, you will receive $5,000 minus commissions and will be debited for 100 shares of stock on the third business day. Keep in mind that you cannot exercise portions of an option -- you either buy or sell in lots of 100 shares. For instance, if you own one contract, you cannot call your broker and use it to only buy 75 shares. You either buy all 100 or none at all. Of course, if you own more than one contract, you can certainly exercise only a portion. If you have five contracts, you could certainly, for example, only exercise two of them and buy 200 shares.
You can always get out of any contract -- long or short -- by executing an offsetting position. For example, if you are long a March $50 call, you can simply sell a March $50 call (called "selling to close") and you no longer have the right to purchase the stock for $50. If you have sold a $75 put (called "selling to open") and no longer want the obligation to buy the stock for $75, you can simply buy a $75 put (buy to close), which relieves you of your obligation. Bear in mind that the price you receive or pay is determined by the market and can be very different from where you entered the contract.
For instance, if you sell a $75 put with the stock at $80, you may receive a small amount, say $2. Later, if the stock is trading for $70, you may wish to get out of the contract. However, that $75 put may now be trading for $6 meaning you sold for $2 and had to pay $6 to exit for a loss of $4 per contract.
In fact, most options are closed out in the open market this way. It's probably less than 5% of the time that contracts are actually exercised. Just be aware that you can always get out of a contract at any time -- it just may cost a lot to do it.
[1] Technically, options expire on the Saturday following the third Friday of the expiration month. However, this is for clearing purposes and there is nothing the option trader can do with an option on Saturday. The third Friday of expiration month is the last trading day so, for practical purposes, it is the day you want to consider as expiration.