Options Theory - Elementary Concepts & Definitions
Types of Options - Calls & Puts
Definitions of Other Basic Options Concepts
An option is the right to buy or to sell a specific financial product (e.g., a stock) at a specified price on or before a specified date.
The financial product on which the option contract is written is called the underlying asset. The person who writes (sells to open) the option is called the writer, and the person who buys the option is called the buyer. The process that the holder (buyer) goes through, in invoking the right to buy or to sell the underlying asset, is called “to exercise” the contract. When a buyer exercises an options contract, a writer of that option is assigned the obligation to sell/buy the underlying asset. The specified price at which the contract is to be exercised is called the strike price. The specified date on which the contract expires is called the expiration date. After this date, the option ceases to exist.
Types of Options: Calls & Puts
From the point of view of the option buyer:
A call option is the type of option that gives the holder the right, but not the obligation, to buy the underlying asset at the strike price on or before the expiration date.
A put option is the type of option that gives the holder the right, but not the obligation, to sell the underlying asset at the strike price on or before the expiration date. Additionally, in each case, the option holder has the right to sell the option contract, to another market participant, before its expiration date.
From the point of view of the option writer:
The writer of a call option has the obligation to sell the underlying asset at the strike price, if assigned. The writer of a put option has the obligation to buy the underlying asset at the strike price, if assigned. Additionally, the writer does have the ability to end this obligation, by “buying to close” the option, before expiration. The writer of an option has no control over whether or not a contract is exercised and needs to be prepared to fulfill the obligation, to sell or to buy the underlying asset at the specified price, if assigned at any time during the life of the contract.
An option is a financial derivative. As such, it derives its value from the price of an underlying asset. When the price of the underlying asset fluctuates, the price of the option does so as well (either in the same direction or in the opposite direction, depending on whether the option is a call or a put).
A rise in the price of the underlying generally causes a rise in the value of its call options and a decline in the value of its put options. Conversely, a decline in the price of the underlying generally causes a decline in the value of its call options and a rise in the value of its put options.
Unlike the underlying asset, however, an option is actually a “wasting” asset. In other words, its (time) value generally diminishes with the passage of time. In fact, there is even a very good possibility that a given option will expire with no value (or worthless).
P/L Diagrams of generic Calls, Puts, resp.This facet of options pricing is, generally speaking, to the detriment of the option buyer and to the benefit of the option writer. On the right, you'll see depictions of the profit and loss payoff of generic call and put options, respectively.
We’ll take a closer look at options pricing diagrams in the 'Introduction to Options Pricing' article. For now, just get a feel of the concept by glancing at the two basic “hockey stick” diagrams on the right.
As you can see, the Call experiences increasing gains as the underlying stock rises, and suffers a limited loss if it declines. The Put, on the other hand, experiences increasing gains as the underlying stock declines, and suffers a limited loss if it rises.
Earlier, we'd mentioned that an option could potentially expire worthless; let’s now try and understand why this might happen. When an option expires, it has an easily definable value (unlike during the life of the contract, when its value depends on a handful of factors and can sometimes require tedious calculation). This value is either zero, or greater than zero, and is arrived at as illustrated below.
In the case of a Call Option: Underlying Price - Strike Price = Call Option Value (at expiration)*
In the case of a Put Option: Strike Price - Underlying Price = Put Option Value (at expiration)*
* Subject to a lower bound of zero.
Examples:
a) DIA 105.0 Calls that expire with DIA trading at 107.50 have a closing value of $2.50
b) SPY 130.0 Calls that expire with SPY trading at 127.50 have a closing value of $0.00
c) MMM 75.0 Puts that expire with MMM trading at 73.75 have a closing value of $1.25
d) PG 60.0 Puts that expire with PG trading at 61.25 have a closing value of $0.00
An option is said to be trading at-the-money, when the underlying is trading virtually at the strike price of the option. If an option is at-the-money at the time of expiration, it expires worthless. Note that it is also common practice to utilize the term "at-the-money," when referring to options that are trading close to (even if not exactly at) the strike price, before expiration.
An option is said to be in-the-money, when the underlying stock is trading at a level that would leave a positive non-zero value on the option, if it were to expire immediately. So, a call option is in-the-money when the underlying is trading above the strike price, and a put option is in-the-money when the underlying is trading below the strike price.
An option is said to be out-of-the-money, when the underlying stock is trading at a level that would not leave a positive value on the option, if it were to expire immediately. So, a call option is out-of-the-money when the underlying is trading below the strike price of the option, and a put option is out-of-the-money when the underlying is trading above the strike price of the option.
Examples:
a) DIA 105.0 Calls, with DIA trading at 107.50 before expiration, are $2.50 in-the-money
b) SPY 130.0 Calls, with SPY trading at 127.50 before expiration, are $2.50 out-of-the-money
c) DIA 105.0 Calls and SPY 130.0 Calls, with the underlying ETFs trading at 105.0 and 130.0, respectively, before expiration, are at-the-money
d) MMM 75.0 Puts, with MMM trading at 73.75 before expiration, are $1.25 in-the-money
e) PG 60.0 Puts, with PG trading at 61.25 before expiration, are $1.25 out-of-the-money
f) MMM 75.0 Puts and PG 60.0 Puts, with the underlying stocks trading at 75.0 and 60.0, respectively, before expiration, are at-the-money
Definitions of Other Basic Options Concepts
American-style Option
This is a style of option contract that can be exercised anytime during its life. All stock options traded in the U.S. are American-style option contracts.
Automatic Exercise (at expiration)
In order to protect the unaware option holder, the OCC has formulated a process of “automatic exercise” whereby that body automatically exercises any option that is even slightly in-the-money (the precise amount tends to be changed from time to time) at expiration. This mechanism has been instituted in order to ensure that no holder throws away gains, through carelessness.
Classes (Chains) and Series
A class (chain) of options refers to all put and call contracts on the same underlying security. E.g. All SPY options – puts and calls at various strikes and expiration months – form one class.
A series, which is a subset of a class, consists of all contracts of a given class that have the same expiration date and strike price. E.g. the SPY Jun 137.0 Put series, the DIA Jun 105 Call series...
Contract Size
The number of shares in the underlying that make up an options contract. Leaving aside special contracts, each options contract on a U.S. stock usually has a contract size of 100 shares.
Exercise and Assignment
To exercise an option is to invoke the right - the right of a call buyer to buy the underlying security and the right of a put buyer to sell the underlying security - granted under the terms of the contract.
Assignment is the process by which an option writer is ordered to fulfill his obligation - the obligation of a call writer to deliver the underlying security and the obligation of a put writer to take delivery of the underlying security - in an options contract, upon exercise of that option contract.
Expiration Date/ Expiration Month
The day – typically the Saturday following the third Friday of the expiration month – on which an options contract ceases to exist. At this date the option may be worth a certain positive amount – equivalent to its intrinsic value – or may be worthless.
At any given point, stock options for two near-term expiration months plus two additional expiration months from the January-, February- or March- quarterly cycles, are typically listed and available for trading. Long-terms options - in the form of “LEAPS” - for the January expiration months from the forthcoming 39-month period, are typically also available.
European-style Option
This style of option can be exercised only at the end of its life (i.e. at expiration). A handful of index options in the U.S. have European-style exercise requirements.
Long Options Position
A purchased call or put. A call buyer is said to have a long call position. A put buyer is said to have a long put position.
Options Combination
An options position that consists of multiple series of options. Through the use of an options combination, a trader can implement a myriad of directional and volatility biases into his/her trading.
Open Interest
Open Interest is the number of currently open positions in a given option series. Note that an order to open an option position adds to open interest; an order to close an option position lessens open interest. The exchanges keep a record of the open interest in each respective series of options and report these numbers in real-time.
Put-Call Ratios
Put-Call ratios are derived from the volume statistics of puts and calls traded on a given underlying. Specifically, the put-call ratio is the ratio of the number of puts traded divided by the number of calls traded in an underlying over a given time period (usually one day). Occasionally, Put-Call ratios are calculated based on open interest or on total dollars spent on calls versus puts.
Short Options Position
A written (sold short) call or put. A call writer (seller) is said to have a short call position. A put writer (seller) is said to have a short put position.
Volatility Index
A volatility index, in general, measures the “implied volatility” of a particular underlying. Implied volatility is a slightly contrived concept that is followed by many options traders, especially those who adhere to theoretical option pricing models such as the Black-Scholes-Merton model.
