Both put and call options have three basic characteristics: exercise price, expiration date and time to expiration.
- The buyer has the right to buy or sell the asset.
- To acquire the right of an option, the buyer of the option must pay a price to the seller. This is called the option price or the premium.
- The exercise price is also called the fixed price, strike price or just the strike and is determined at the beginning of the transaction. It is the fixed price at which the holder of the call or put can buy or sell the underlying asset.
- Exercising is using this right the option grants you to buy or sell the underlying asset. The seller may have a potential commitment to buy or sell the asset if the buyer exercises his right on the option.
- The expiration date is the final date that the option holder has to exercise her right to buy or sell the underlying asset.
- Time to expiration is the amount of time from the purchase of the option until the expiration date. At expiration, the call holder will pay the exercise price and receive the underlying securities (or an equivalent cash settlement) if the option expires in the money. (We will discuss the degrees of moneyness later in this session.) The call seller will deliver the securities at the exercise price and receive the cash value of those securities or receive equivalent cash settlement in lieu of delivering the securities.
- Defaults on options work the same way as they do with forward contracts. Defaults on over-the counter option transactions are based on counterparties, while exchange-traded options use a clearing house.
Example: Call Option
IBM is trading at 100 today. (June 1, 2005)
The call option is as follows:Strike price = 120, Date = August 1, 2005,Premium on the call = $3
In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for the right to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercise the option on or before August 1, 2005, the seller will have to deliver IBM shares at a price of $125 to the buyer.
Example: Put Option
IBM is trading at 100 today (June 1, 2005)
Put option is as follows:Strike price = 90, Date = August 1, 2005, Premium on the put = $3.00
In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right to sell IBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise the option on or before August 1, 2005, the seller will have to purchase IBM shares at a price of $90.
Example: Interpreting Diagrams
For the exam, you may be asked interpret diagrams such as the following, which shows the value of a put option at expiration.
A typical question about this diagram might be:
Q: Ignoring transaction costs, which of the following statements about the value of the put option at expiration is TRUE?A. The value of the short position in the put is $4 if the stock price is $76.
B. The value of the long position in the put is $4 if the stock price is $76.
C. The long put has value when the stock price is below the $80 exercise price.
D. The value of the short position in the put is zero for stock prices equaling or exceeding $76.
The correct answer is "C". A put option has positive monetary value when the underlying instrument has a current price ($76) below the exercise price ($80).
InvestingLearn more about stock options, including some basic terminology and the source of profits.
TradingA brief overview of how to profit from using put options in your portfolio.
InvestingThere are times when an investor shouldn't exercise an option. Find out when to hold and when to fold.
TradingA brief overview of how to provide from using call options in your portfolio.
TradingLearn the top three risks and how they can affect you on either side of an options trade.
TradingOptions offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
InvestingDiscover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
TradingThe adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably.
TradingAs long as the underlying stocks are of companies you are happy to own, put selling can be a lucrative strategy.
MarketsA look at trading options on debt instruments, like U.S. Treasury bonds and other government securities.