What are options contracts and how do they work?
An option contract is a traded security that grants its holder the right or “option” (but not the obligation) to buy or sell a predetermined amount of the underlying asset (usually 100 shares) at a specified price (the “strike” of the contract). price”) no later than a certain date (the expiration date of the contract). Call options give their holders the right to buy shares, and put options give their holders the right to sell them.
Because option contracts derive both their value and their risk from a non-underlying asset (usually a stock), they are considered derivatives or simply “derivatives”. Other types of derivative contracts include futures, forwards, and swaps.
Essentially, options contracts allow traders to bet (and ideally profit) on future changes in stock prices without actually owning those shares.
What are the 2 types of option contracts?
There are two different types of option contracts, each of which provides its buyer with different rights.
The owner (buyer) of a call option has the right buy 100 shares from the seller of the option at the strike price specified in the contract, at any time before the expiration of the contract. Alternatively, they can resell the contract on the open market. Call options acquire value when the price of the underlying stock Continuestherefore they are considered bullish.
Call option example
For example, if an investor believes that Apple’s share price will rise after the earnings announcement, he can buy a call option with an exercise price close to Apple’s spot price (current market value) that expires one week after the earnings announcement. planned.
If the call succeeds because Apple outperforms earnings estimates and the price of Apple’s stock rises as a result, the investor can then resell their call option for more than they paid for it, or exercise it to buy 100 Apple shares at expiration. price, which is now below the market. In other words, they can either resell their contract at a profit or buy 100 shares at a discount.
The owner (buyer) of a put option has the right sell 100 shares to the seller (seller) of the option at the strike price specified in the contract, at any time before the expiration of the contract. Alternatively, they can resell the contract on the open market. Put options acquire value when the price of the underlying stock going downtherefore they are considered bearish.
Put option example
For example, if an investor believes Tesla’s stock price will fall due to a shortage of chips and looming supply chain problems, they can buy a put option with an exercise price close to Tesla’s spot price (current market value) that is expiring. after a few months.
If a shortage of chips and a slowdown in the supply chain does affect Tesla’s production and sales, and the stock price falls as a result, an investor can resell his put option for more than he paid for it or use it to sell 100 Tesla. shares at an exercise price that is currently above market value. In other words, they can either resell their contract for a profit or sell 100 shares for more than they’re worth, pocketing the difference.
Scroll to continue
TheStreet glossary terms
What is the strike price of the option?
In an option contract, the strike price is the agreed price at which the underlying security can be bought (in the case of a call option) or sold (in the case of a put option) by the option holder before or after the expiration of the contract. The term exercise price is used interchangeably with the term exercise price.
Intrinsic Value: The strike price versus the spot price
The spot price of an option contract, on the other hand, is the current market value of the underlying stock or asset. It is constantly changing, and the strike price remains unchanged. The relationship between the strike price of the option and the spot price is part of what determines the value of the contract.
For example, if the strike price of a call option below At its spot price, it has intrinsic value because it can be used to buy 100 underlying shares at below market price. Similarly, if a put’s strike price is higher than its spot price, it has intrinsic value because it can be used to sell 100 shares of the underlying for more than it’s worth.
It is important to remember that an option’s intrinsic value (the discount or premium at which shares can be bought or sold respectively) is always included in its premium (the market price of the contract).
What is an option premium?
An option’s premium is its market price or the amount the buyer must pay to own the contract, not the market price of the underlying stock. This price can change over time and depends on three factors: intrinsic value, time value, and the volatility of the underlying stock or asset.
An option has intrinsic value if it can be used to buy shares at a discount or sell them at a premium. You can think of an option’s intrinsic value as the difference between its strike price and its market price (if that’s to the buyer’s advantage).
In the case of a call, an option has intrinsic value if the strike price is below the market price. In a put, an option has intrinsic value if the strike price is higher than the market price. As mentioned above, an option’s intrinsic value is always included in its premium.
For example, if the strike price of a call option was $2 below its spot price, its intrinsic value would be $200 ($2 * 100 shares), so its premium would be at least $200. If the strike price of a call option were $2 above its spot price, it would have no intrinsic value, so its premium would be entirely determined by its time value and the volatility of the underlying stock.
The time value of an option contract depends on how much time is left until the expiration of the contract. The longer the duration of the contract, the higher its time value. When the contract expires, there is little time for the value of the underlying asset to change, whereas when the contract expires in months, there is enough time for the underlying asset to change in value.
Among other factors, options have higher premiums the farther they are from expiration. It is also important to remember that time value decreases faster the closer the contract expires. In other words, it decreases exponentially rather than linearly—an effect sometimes referred to as “time decay.”
Volatility of the underlying asset
Volatility, sometimes measured in terms of standard deviation, is the degree to which the price of an underlying asset changes regularly. The higher the volatility of the underlying stock, the higher the premium of the option contract, other things being equal. The more a stock fluctuates in price, the more likely it is to get into or out of the money in a short period of time.
With money vs without money
If an option contract has an intrinsic value, it is considered “in the money” and its intrinsic value is included in its premium. If an option contract has no intrinsic value, it is considered out of the money, and its premium is based primarily on its time value and volatility, which together determine the likelihood that the contract will be in the money. its expiration time.
If the strike price of a contract is equal to its spot price (the current market value of the underlying stock), it is considered in-the-money.