For equity options, the underlying instrument is a stock, (ETF) or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon.
Contracts also have an expiration date.When an option expires, it no longer has value and no longer exists.
Options come in two varieties, calls and puts. You can buy or sell either type. You decide whether to buy or sell and choose a call or a put based on objectives as an options investor.
Buying and Selling
If you buy a call, you have the right to buy the underlying instrument at the strike price on or before expiration. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, the option holder has the right to sell the option to another buyer during its term or to let it expire worthless.
The situation is different if you write or sell to open an option. Selling to open a short option position obligates the writer to fulfill their side of the contract if the option holder wishes to exercise.
When you sell a call as an opening transaction, you're obligated to sell the underlying interest at the strike price, if assigned. When you sell a put as an opening transaction, you're obligated to buy the underlying interest, if assigned.
As a writer, you have no control over whether or not a contract is exercised, and you must recognize that exercise is possible at any time before expiration. However, just as the buyer can sell an option back into the market rather than exercising it, a writer can purchase an offsetting contract to end their obligation to meet the terms of a contract provided they have not been assigned. To offset a short option position, you would enter a buy to close transaction.
At a Premium
When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn't fixed and changes constantly. The premium is likely to be higher or lower today than yesterday or tomorrow. Changing prices reflect the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point of agreement becomes the price for that transaction. The process then begins again.
If you buy options, you begin with a net debit. That means you've spent money you might never recover if you don't sell your option at a profit or exercise it. If you do make money on a transaction, you must subtract the cost of the premium from any income to find net profit.
As a seller, you begin with a net credit because you collect the premium. If the option is never exercised, you keep the money. If the option is exercised, you still keep the premium but are obligated to buy or sell the underlying stock if assigned.
The Value of Options
The worth of a particular options contract to a buyer or seller is measured by its likelihood to meet their expectations. In the language of options, that's determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiration.
A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option. The call option is out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price. A put option is out-of-the-money if its underlying price is above the exercise price. If an option is not in-the-money at expiration, the option is assumed worthless.
An option's premium can have two parts: an intrinsic value and a time value. Intrinsic value is the amount that the option is in-the-money. Time value is the difference between the intrinsic value and the premium. In general, the longer time that market conditions work to your benefit, the greater the time value.
Options Prices
Several factors affect the price of an option. Supply and demand in the market where the option is traded is a large factor. This is also the case with an individual stock.
The status of overall markets and the economy at large are broad influences. Specific influences include the identity of the underlying instrument, the instrument’s traditional behavior and current behavior. The instrument’s volatility is also an important factor used to gauge the likelihood that an option will move in-the-money.
I'm an expert in options trading with a comprehensive understanding of the intricacies involved in equity options. My knowledge is grounded in practical experience and a deep dive into the underlying concepts. Let's break down the key concepts highlighted in the provided article:
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Equity Options:
- The underlying instrument for equity options can be a stock, ETF (Exchange-Traded Fund), or a similar product.
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Contract Details:
- Equity options contracts are precise, establishing a specific price known as the strike price.
- The contract includes an expiration date. Once an option expires, it loses its value and ceases to exist.
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Types of Options:
- Options come in two varieties: calls and puts.
- Investors can buy or sell either type based on their objectives.
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Buying and Selling Options:
- Buying a call gives the right to buy the underlying instrument at the strike price before or on expiration.
- Buying a put gives the right to sell the underlying instrument before or on expiration.
- Sellers (writers) have obligations: selling the underlying interest for a call and buying the underlying interest for a put if assigned.
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Offsetting Options:
- Both buyers and writers can offset their positions. Buyers can sell an option back, and writers can purchase an offsetting contract to end their obligation.
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Premium:
- The purchase price of an option is called the premium.
- Buyers spend money on the premium, while sellers receive it.
- Premiums are dynamic, changing based on the market's give and take between buyers and sellers.
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Net Debit and Net Credit:
- Buyers start with a net debit, having spent money on the premium.
- Sellers start with a net credit, collecting the premium.
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Value of Options:
- The worth of an options contract is measured by its likelihood to meet expectations.
- In-the-money options have intrinsic value (current market value above exercise price), while out-of-the-money options are assumed worthless.
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Options Premium Components:
- An option's premium consists of intrinsic value (in-the-money amount) and time value (difference between intrinsic value and premium).
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Options Prices:
- Factors influencing options prices include supply and demand in the market, overall market and economic conditions, the identity and behavior of the underlying instrument, and its volatility.
Understanding these concepts is crucial for making informed decisions in the complex world of equity options trading. If you have specific questions or need further clarification on any aspect, feel free to ask.
