Investors use options to speculate (bet) on market price movements, protect portfolios from risk, and generate income. Each strategy comes with its own risks, benefits, and typical users.
Options are contracts between two parties:
For example, if an option buyer has the right to purchase stock at $50, the option seller must sell the stock at $50 (if the buyer exercises their right).
Options don’t last forever. Each option has a defined expiration date. Most options expire within nine months after issuance*, but longer-term options exist. The option buyer has until expiration to exercise their right. If the option isn’t exercised by expiration, it expires and no longer exists. Standard options with expirations of up to nine months typically expire on the third Friday of the expiration month at 11:59pm ET**.
*Like most securities, options are issued to investors in the primary market, then are traded in the secondary market. Both of these markets are covered in detail in future chapters.
**Options primarily trade in Chicago on the CBOE (Chicago Board Options Exchange). Chicago is in the Central time zone, which is one hour behind Eastern. When you encounter test questions on expiration, be careful and watch for time zones!
While many options expire within nine months of issuance, one notable exception exists. LEAPS (long-term equity anticipation securities) are long-term options that last up to three years. They allow investors to take positions on stock prices over longer periods.
Options are derivative securities, meaning they get (derive) their value from price changes in an underlying asset. The underlying asset could be a stock, an index, a currency, or a commodity. When the market value of the underlying asset changes, the option’s value tends to change as well.
For example, an option that allows an investor to buy stock at $50 becomes more valuable as the stock’s market price rises. If the market price rises to $90, the option allows the investor to buy the stock $40 below market value. The higher the market price rises, the more valuable the option (and vice versa).
There are two primary types of options contracts:
Equity (stock) options derive their value from the price fluctuations of a specific stock. For example, if you bought or sold an Apple Inc. (ticker: AAPL) option, you’d pay close attention to Apple’s stock price. Depending on the option you invest in, you may make money if Apple’s stock price falls, stays flat, or rises. You could use an Apple option to speculate on its price, protect your Apple stock investment, or generate additional income in your portfolio.
Index options derive their value from fluctuations in a specific index’s value. For example, you could invest in an S&P 500 index option that may provide a return if the index value falls, stays flat, or rises. Index options are used to speculate on general market movements, generate additional income, or protect entire portfolios from market risk.
Options can feel like a new language at first, so the vocabulary matters. One of the most important ideas is the difference between buying and selling contracts.
‘Long’ is a term used across the securities industry. If an investor is ‘long’ a security, they purchased and continue to hold it. We use the term with options too, but with a specific meaning: when an investor goes long an option, they buy a contract that gives them a specific right.
An investor who is long an option is called a holder. Holders have the right to buy or sell an asset at a particular price (depending on the contract).
The cost of an option is its premium. Option buyers pay a premium to purchase an option, and in return they receive a specific right. In general, the more valuable the option, the higher its premium.
For example, if a stock’s market price is $70 and an options contract provides the right to buy the stock at $50, the premium will be at least $20 per share. Premiums are determined in the options markets and move based on supply and demand, similar to stock prices. More demand tends to push the premium higher (and vice versa).
Premiums can be expensive, so holders need the option to gain enough value to offset its cost. When you buy an option, you incur a debit (a cost) to go long.
A bad outcome for a holder is for the option to expire unused. If that happens, the holder’s loss equals the premium paid (this is the maximum potential loss for a holder).
Assume an investor purchases an option that provides the right to buy a stock at $50. If the stock’s market price falls to $40, the buyer won’t use the option. There’s no reason to exercise the option and buy at $50 when the market offers the stock for $40. In this scenario, the option has no intrinsic value.
Intrinsic value is the profit the holder makes when an option is exercised. When exercising isn’t profitable (as in the example above), the option has no intrinsic value. Options without intrinsic value are called “out of the money” (OTM). In the example, the option was out of the money by $10.
If an option is still out of the money on the expiration date, it expires worthless. The holder then absorbs the maximum potential loss: the premium paid for an option they didn’t use.
Now assume an investor purchases an option that gives the right to buy the stock at $50. If the stock price rises to $75, the holder can lock in a gain by exercising and buying the stock at $50, then selling it in the market for $75. When an option is in “exercise territory,” it has intrinsic value. In this example, the option has $25 of intrinsic value. An option with intrinsic value is called “in the money” (ITM).
In summary, option purchasers are long options and are called holders. Holders pay premiums (creating a debit) to gain the right to transact at a fixed price before expiration, and they hope the option goes in the money (gains intrinsic value) so exercising is profitable.
When investors sell an option, they go short. With options, the terms ‘sell’ and ‘short’ are used interchangeably.
When an investor sells an option, they may take on significant risk. To deliver the rights given to the holder, the seller obligates themselves to do something they may not want to do. The seller accepts that obligation because they receive a premium in return.
Option sellers are credited a premium when they go short options. That premium is an immediate benefit, but the position can turn out well or poorly. In the best-case scenario, the option expires worthless and the seller’s obligation disappears.
Option sellers are also called writers. The idea is that the seller is “writing” a contract and selling it to another investor.
Writers want the options they sell to expire worthless and avoid gaining intrinsic value. Remember: intrinsic value is the profit the holder would make by exercising. The holder’s profit is the writer’s loss. So, the more intrinsic value a contract has, the more the writer loses. That’s why writers want their options to stay out of the money (OTM) (with no intrinsic value). Let’s walk through an example.
An investor sells an option that gives the holder the right to buy stock at $50. The investor (the option seller/writer) is obligated to sell the stock at $50, but only if the holder exercises.
If the market price falls to $45 per share, the holder won’t exercise. There’s no reason to buy at $50 when the market offers the stock at $45. If the market price stays there through expiration, the writer isn’t forced to do anything. The writer earns the maximum gain: the premium received when the option was sold. The option had no intrinsic value and was out of the money at expiration.
Conversely, if the stock rises to $70 per share, the holder will exercise the right to buy at $50. The contract has $20 of intrinsic value and is in the money.
When a writer’s option is exercised, the writer is “assigned” and must perform the obligation. In this example, the writer must sell the stock at $50. If the writer doesn’t already own the stock, they must buy it in the market at $70 and then sell it to the holder at $50. That locks in a $20 per share loss. The writer still keeps the premium, but the premium may not offset the loss created by assignment.
This is why option sellers hope their contracts go unexercised: they want to collect the premium and have the option expire worthless.
In summary, option sellers are short options and are called writers. Writers receive premiums (creating a credit) in exchange for obligating themselves to perform a transaction at a fixed price. They hope their options remain out of the money (without intrinsic value) and expire worthless.
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