Chapter 1: What is a Security? - F. Characteristics of All Options

All option contracts are issued and their performance is guaranteed by the Options Clearing Corporation (OCC). Standardized options trade on the exchanges, such as the Chicago Board Options Exchange and the American Stock Exchange.

All option contracts are for one round lot of the underlying security, or 100 shares. To determine the amount that an investor either paid or received for the contract, take the premium and multiply it by 100. If an investor paid $4 for 1 KLM August 70 call. They paid $400 for the right to buy 100 shares of KLM at $70 per share until August.

Exercise Price

The exercise price is the price at which an option buyer may buy or sell the underlying security, depending on the type of option involved in the transaction.

Buyer vs. Seller

Buyer Seller
Known as Owner Writer
Objective Long Short
Objective Maximum speculative profit Premium income
Wants the option to Exercise Expire

Possible Outcomes for an Option

-Exercised

If the option is exercised, the buyer has elected to exercise their rights to buy or sell the security depending on the type of option involved. Exercising an option obligates the seller to perform under the contract.

-Sold

Most individual investors will elect to sell their rights to another investor rather than exercise their rights. The investor who buys the option from them will acquire all the rights of the original purchaser.

-Expire

If the option expires, the buyer has elected not to exercise their right and the seller of the option is not required to perform.

Option Premiums

The price of an option is known as its premium. Factors that determine the value of an option and, as a result, its premium, are:

  • The Relationship of The Underlying Stock Price to The Option’s Strike Price
  • The Amount of Time To Expiration
  • The Volatility of The Underlying Stock
  • Supply and Demand
  • Interest Rates

An Option can be:

  • In The Money
  • At The Money
  • Out of The Money

These terms describe the relationship of the underlying stock to the option’s strike price. These terms do not describe how profitable the position is.

In The Money Options

A call is in the money when the underlying stock price is greater than the call’s strike price.

Example:

An XYZ June 40 Call is $2 in the money when XYZ is at $42 per share.

A put is in the money when the underlying stock price is lower than the put’s strike price.

Example:

An ABC October 70 Put is $4 in the money when ABC is at $66 per share.

It would only make sense to exercise an option if it was in the money.

At The Money Options

Both puts and calls are at the money when the underlying stock price equals the options exercise price.

Example:

If FDR is trading at $60 per share, all of the FDR 60 calls and all of the FDR 60 puts will be at the money.

Out of The Money Options

A call is out of the money when the underlying stock price is lower than the option’s strike price.

Example:

An ABC November 25 call is out of the money when ABC is trading at $22 per share

A put option is out of the money when the underlying stock price is above the option’s strike price.

Example:

A KDC December 50 put is out of the money when KDC is trading at $54 per share.

It would not make sense to exercise an out of the money option.

Calls Puts

In the Money

Stock Price > Strike Price

Stock Price < Strike Price

At The Money

Stock Price = Strike Price

Stock Price = Strike Price

Out of The Money

Stock Price < Strike Price

Stock Price > Strike Price

Intrinsic Value and Time Value

An option’s total premium is comprised of intrinsic value and time value. An option’s intrinsic value is equal to the amount the option is in the money. Time value is the amount by which an option’s premium exceeds its intrinsic value. In effect, the time value is the price an investor pays for the opportunity to exercise the option. An option that is out of the money has no intrinsic value; therefore, the entire premium consists of time value.

A. Introduction: Brokerage Office Procedures & Back Office Operations


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