Option basics
What an option is, who holds which right and which obligation, how a contract is quoted, read and settled, and what can go wrong.
- What is an option?
An option is a contract that gives its holder the right, and not the obligation, to buy or to sell 100 shares of a stock at a fixed price until a fixed date.
- Calls and puts
A call option is the right to buy 100 shares of a stock at the strike price, and a put option is the right to sell 100 shares at the strike price, until the option expires.
- Option buyers and sellers: rights and obligations
The buyer of an option is the holder of a right and has no obligation. The seller, called the writer, is obliged to fulfil the contract when the holder exercises, and receives the premium for taking that on.
- Strike price, expiration date and premium
The strike price is the price per share at which the shares of an option are bought or sold, the expiration date is the last day of the option, and the premium is the price paid for the option.
- One option contract is 100 shares
One standard stock option contract covers 100 shares of the underlying stock, so every quoted premium is multiplied by 100 to get the price of one contract.
- How to read a payoff diagram
A payoff diagram is a chart of the profit or loss of an option position at expiration for every price of the underlying stock.
- Moneyness, intrinsic value and time value
Moneyness is where the price of the stock stands against the strike price of an option, intrinsic value is the amount by which the option is in the money, and time value is the rest of its premium.
- How to read an option chain
An option chain is the table of every listed option on one stock, arranged by expiration date and strike price, with the calls on one side and the puts on the other.
- Exercise, assignment and expiration day
Exercise is the use of the right in an option by its holder, assignment is the notice that obliges a writer to fulfil the contract, and expiration day is the last day on which either can happen.
- The main risks of options
The main risks of options are the loss of the whole premium for a buyer, a loss far larger than the premium for a seller, and the effects of leverage, of time and of assignment on both.