Many traders think of a position in stock options as a stock substitute that has higher leverage and less required capital. After all, options can be used to bet on the direction of a stock's price, just like the stock itself. However, options have different characteristics than stocks, and there is a lot of terminology beginning option traders must learn.
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The two types of options are calls and puts. When you buy a call option, you have the right but not the obligation to purchase a stock at the strike price any time before the option expires. When you buy a put option, you have the right but not the obligation to sell a stock at the strike price any time before the expiration date.
One important difference between stocks and options is that stocks give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. It is important to remember that there are always two sides for every option transaction: a buyer and a seller. So, for every call or put option purchased, there is always someone else selling it.
When individuals sell options, they effectively create a security that didn't exist before. This is known as writing an option and explains one of the main sources of options, since neither the associated company nor the options exchange issues options. When you write a call, you may be obligated to sell shares at the strike price any time before the expiration date. When you write a put, you may be obligated to buy shares at the strike price any time before expiration.
Trading stocks can be compared to gambling in a casino, where you are betting against the house, so if all the customers have an incredible string of luck, they could all win.
Trading options is more like betting on horses at the racetrack. There they use parimutuel betting, whereby each person bets against all the other people there. The track simply takes a small cut for providing the facilities. So, trading options, like the horse track, is a zero-sum game. The option buyer's gain is the option seller's loss and vice versa. Any payoff diagram for an option purchase must be the mirror image of the seller's payoff diagram.
The price of an option is called its premium. The buyer of an option cannot lose more than the initial premium paid for the contract, no matter what happens to the underlying security. So, the risk to the buyer is never more than the amount paid for the option. The profit potential, on the other hand, is theoretically unlimited.
In return for the premium received from the buyer, the seller of an option assumes the risk of having to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that option is covered by another option or a position in the underlying stock, the seller's loss can be open-ended, meaning the seller can lose much more than the original premium received.
You should be aware that there are two basic styles of options: American and European. An American-style option can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style, and all stock options are American style. A European-style option can only be exercised on the expiration date. Many index options are European style.
When the strike price of a call option is above the current price of the stock, the call is out of the money; when the strike price is below the stock's price, it is in the money. Put options are the exact opposite, i.e., out of the money when the strike price is below the stock price and in the money when the strike price is above the stock price.
Note that options are not available at just any price. Stock options are generally traded with strike prices in intervals of $0.50 or $1, but can be in intervals of $2.50 and $5 for higher-priced stocks. Also, only strike prices within a reasonable range around the current stock price are generally traded. Far in- or out-of-the-money options might not be available.
All stock options expire on a certain date, called the expiration date. For normal listed options, this can be up to nine months from the date the options are first listed for trading. Longer-term option contracts, called LEAPS, are also available on many stocks, and these can have expiration dates up to three years from the listing date.
Options expire at market close on Friday, unless it falls on a market holiday, in which case expiration is moved back one business day. Monthly options expire on the third Friday of the expiration month, while weekly options expire on each of the other Fridays in a month.
Unlike shares of stock, which have a three-day settlement period, options settle the next day. In order to settle on the expiration date, you have to exercise or trade the option by the end of the day on Friday.
The Bottom Line
Most option traders use options as part of a larger strategy based on a selection of stocks, but because trading options is very different from trading stocks, stock traders should take the time to understand the terminology and concepts of options before trading them.