Introduction
All investors know that buying stock entitles them to partial ownership in the corporate entity issuing those shares. In other words, you are purchasing an "equity" participation in the company. Most stocks listed and traded on
Let's define the option contract a little further. Equity options, like stock, are classified as securities. More specifically, though, equity options are termed "derivative" securities. This term implies that their value is in part based on, or derived from, the value of their particular underlying stocks. As securities, they are available for trading on any of the exchanges in this country that list equity options. Just as the stock market, the Securities and Exchange Commission (SEC) oversees trading of all exchange-listed equity options in the
Are options a new thing? No, they've been around for centuries. There is even evidence that the ancient Greeks used option-like contracts to guarantee market prices for their olive crops. However, until the mid 20th century the options marketplace was a loose, largely unregulated affair, and the terms of option contracts were not standardized. Until this time option contracts were tailored to fit the specific needs of the individual investors purchasing them; i.e. with respect to when they expired, and both the number and price of the underlying shares that would change hands when they could be exercised. Investors wishing to sell these specialized option contracts resorted to advertising them for sale in financial newspapers. At best, this was an awkward way to do business. This all changed, however, with the advent of
Today, there are many options exchanges both in the
Terminology
Let's introduce our discussion on option basics by defining some terms, some of which are specific to the option industry, and with a brief overview of the mechanics of the options marketplace. Covering this now will make it easier to understand the material discussed later in this and other online classes on this Web site.
Again, an equity option is a contract. To the investor purchasing and holding an option, this contract conveys a right to either purchase or sell shares of the underlying stock. There are two types of standardized equity options, calls and puts.
Buy Call = Right to Buy 100 Shares
Buy Put = Right to Sell 100 Shares
A standard equity call option (including LEAPS®) conveys a right, not an obligation, to its holder to purchase 100 shares of the underlying stock, at a specific price per share, for a predetermined amount of time. An equity put option, on the other hand, conveys a right to its holder to sell 100 shares of the underlying stock, at a specific price per share, for a predetermined amount of time. An investor who holds one of these options in a trading account is commonly said to have a position in that contract.
If the holder of an equity option decides he or she wants to actually purchase (in the case of a call) or sell (in the case of a put) shares of the underlying stock at the exercise price, that investor "exercises" the option. Notifications of intent to exercise must be submitted to the investor's brokerage firm. Each firm may have specific procedures and cut-off times for exercising equity options, so it is your responsibility to become familiar with your brokerage firm's rules on this matter.
Who sells an option contract to a buyer? One of two people - either a person who has purchased an option and wants to liquidate (or close out) this position, or a person who has no position in the contract and who chooses to create, or write it. These people can be either professional option traders, who as "members" of an option exchange have the obligation to make bid and ask prices, or other investors like you. However, if you are purchasing an equity call or put contract to own it (in your brokerage account), it does not matter which of these people sells it to you. Once your purchase order is actually transacted at an options exchange, you own the option contract. The motivations for an investor to either purchase or write an equity option contract are many. We'll touch upon the most basic of these later in this class. As you investigate the many strategies with which you can employ purchased or written calls and puts, you will see that equity options are very flexible financial instruments.
Write Call = Obligation to Sell 100 Shares
Write Put = Obligation to Buy 100 Shares
Remember that the investor purchasing either a call or put option is buying a right to either buy or sell shares of the option's underlying stock. Again, this is a right that is being purchased, not an obligation. The person who writes the option, however, has incurred an obligation to fulfill its terms if called upon to do so. The writer of a call option contract is obligated to sell underlying shares to a call holder, and a put writer is obligated to purchase underlying shares from a put holder, if either of these option holders exercises an option contract with the same standardized terms. At what time must this obligation be met? When the option writer is assigned an exercise notice by his or her brokerage firm.
Let's put the exercise and assignment processes together and look at the mechanics of how this works. You have a call option that you want to exercise because you've decided that you want to actually own shares of the underlying stock. You notify your brokerage firm today that you wish to exercise the call. Again, the timing and method of this notification must comply with your brokerage firm's established procedures. Tonight, your broker notifies The Options Clearing Corporation (OCC) of your intent to exercise.
After receipt of this notification, OCC selects a firm (who is also a member of OCC) with a customer who has written an identical call option contract, and notifies it of your intent to exercise. The firm receiving this notification may be your own brokerage firm, or one of many other member firms. Whichever firm it happens to be, OCC chooses it at random. Once this firm receives the exercise notification, it then assigns this notice to one of its customers who has written a call contract similar to yours. This particular call writer is selected from a pool of such customers, either at random, or by some other procedure specific to the brokerage firm, and will be notified of the assignment in the morning, or the next business day.
When a call writer is assigned this exercise notice, the writer must fulfill his or her obligations that day. In your case, this option writer must sell you shares of the call's underlying stock at the prescribed exercise price per share. These shares will be "physically" transferred into your brokerage account by OCC. If you had instead exercised a put option, the notification process would have worked the same way. However, since the put option gives you the right to sell shares of the underlying stock, the put writer assigned the exercise notice would be obligated to purchase those shares from you at the prescribed exercise price per share.
Now that you've got a picture of how the options marketplace works, let's briefly review the role of The Options Clearing Corporation. You probably noticed that OCC seems to be in the middle of things. It is. By definition, OCC is the common clearing entity, issuer, and guarantor for all 
During any given trading day, after OCC confirms that an options transaction between a buyer and a seller has taken place, it severs the link between the two parties. This transaction is then considered cleared. Whether you purchase an option, or sell one you already own, it doesn't matter from whom you are buying it, or to whom you are selling it. Likewise, if you write an option contract, it does not matter who is buying it from you. The options marketplace is one in which there is no permanent link between any one particular buyer and any one particular seller. Closing option positions in no way affects the rights or obligations of the original party on the other side of the trade. The stock market works much the same way, with its own industry clearing corporations that match stock buyers and sellers.
As a clearing entity, OCC matches option buyers with sellers after a transaction takes place on an option exchange, and option holders who exercise their options with option writers who are to be assigned an exercise notice. As guarantor, OCC ensures that the obligations of options contracts are fulfilled for the selling and purchasing customers of clearing member firms, regardless of the financial condition of the contra party, or who that party is.
OCC also technically issues all
Stock Options?
Note: As exchange-traded equity options are based on underlying stocks, they are commonly referred to as "stock options." However, this term is also commonly used to describe those options issued by corporations to their employees as financial compensation. These options are not listed or traded on any option exchange. Further, this type of option contract is between the holder (employee) and the issuing corporation (the employer). When one of these options is exercised, it is the issuing corporation that will distribute its own shares to the exerciser. We are not referring to this type of option in this class, or any other class on this Web site.
We've talked about buying, selling, and writing option contracts, but there are several specific terms that describe these various transactions and their consequences - long and short, opening and closing.
Buy to Own 
Long Position
A long position, with respect to options or stock, is one in which you have purchased and own that security in your brokerage account. If you've purchased a call or put contract, and are holding that option in your account, you are long the contract and own the rights inherent therein. If you have purchased 1000 shares of stock and hold these shares in your account (or have them in a lock box), you are long those 1000 shares. In another context, however, the term long can also imply a bullish market position in either stock or options. You could say that if you own call options, or own shares of stock, you are long in the market. You have an overall bullish position that would benefit from a price increase of either the call options' underlying stock, or the shares of stock owned.
Write an Option Short Position
The term short implies something quite different. With respect to options, a short position is one in which you have written an option contract. If you've written a call or put option, you are short that contract and have the obligation to fulfill its terms if you are assigned an exercise notice. Selling stock short is a little different. A short stock sale is one in which you are selling shares you do not actually own. When you do this, your brokerage firm will borrow the shares from another investor, with their permission. These borrowed shares then go to the person to whom you sold them in the marketplace. At this point, you have an obligation to return the shares to the lender at some point, either when you decide to, or when that investor wants them back. During the time you are obligated to return this stock to the lender, you are short those shares. In another context, however, the term short can also imply a bearish market position in either stock or options. You could say that if you own put options, or are short shares of stock, you are short in the market. You have an overall bearish position that would benefit from a price decrease of either the put options' underlying stock, or the shares of stock you are short.
Sell or Exercise? Option Owner Decides
While you are long an equity option contract, you own the inherent right to either buy or sell shares of the underlying stock at the exercise price as long as you own that option. This right ceases to exist either after you exercise the option, or when the option expires unexercised. As long as you own this option, it is your prerogative as to whether or when you exercise it, as long as this is on or before its expiration. If you no longer wish to own an option before it expires, you may sell it in the open marketplace if it has market value, and there is a bid price to purchase this option on one of the option exchanges.
Assignment? Possible at Anytime
Remember that when you have written (and are short) an equity option contract, you have an inherent obligation to fulfill, on a timely basis, if you are assigned an exercise notice. While short this contract, you are eligible to be assigned an exercise notice at any time before or at its expiration. It is not your prerogative as to whether or when you will be assigned an exercise notice. That choice belongs to an option holder who chooses, for whatever reason, to exercise it. However, if you no longer wish to be short an option and be obligated to fulfill its terms, you can buy it (or one just like it) back in the open marketplace, if there is an offer price for the contract on one of the options exchanges. If this is done on any given trading day, you will not be vulnerable to assignment on this short option contract the next day. Your obligations will be, in effect, canceled out.
Opening Transaction = Creating or Increasing Position
An opening transaction is one in which you are either creating or increasing a position in that security. If you are purchasing an option to hold in your account, whether you already own a like contract or not, this is an opening purchase transaction. You are creating a long position. If you already own a particular option and purchase another just like it, this is also an opening purchase transaction. In this case you are increasing a long position in that option, from one to two contracts. Conversely, if you are writing an option contract, this is an opening sale transaction. If you have no position in this option, you are creating a short position. If you have already written an option, and write another option contract with the same terms, you are increasing your short position in that option from one to two contracts.
Closing Transaction = Reducing or Eliminating Position
Just the opposite from an opening transaction is a closing transaction. This is one in which you are either reducing or eliminating an open position in that security. If you are buying an option to either reduce or eliminate a short position, this is a closing purchase transaction. You are in effect buying it back and closing out your obligations. If you were short one option contract and bought it back with a closing purchase transaction, you would be eliminating that short position. If you were short two option contracts and were to buy back one contract with the same terms, you would be decreasing a short position in that option, from two to one contract. In either case, you are said to be closing out a short position. Conversely, if you are selling an option to either reduce or eliminate a long position, this is a closing sale transaction. If you own one option contract and sell it in the marketplace, you are eliminating that long position. If you owned two like option contracts and sold one of them, you are reducing that long position from two to one contract.
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| Let's further clarify some terms that we've already used in our discussion here - buyer, purchaser, seller, and writer. A buyer is simply someone who goes to the options marketplace to buy an option. This person may be either buying back (closing out) a short option position, or buying an option to own and hold in a trading account. A subtle distinction between these two is that the investor who is buying an option to own (a long contract) may be said to be its purchaser. It is common in the options industry for the word purchase to imply creating or increasing a long position. |
| What about sellers? Technically anybody selling an option in the marketplace, whether with an opening (short) or closing (long) transaction, can be termed a seller. The marketplace is full of both types. However, it is not uncommon for the term seller to describe an investor (or a professional) who is writing an option, or creating a short position. The exact implication of this word can usually be gleaned from the context in which it is being used. To avoid confusion, however, from this point forward we will use the term writer to specifically describe a person who is selling an equity option contract with an opening transaction, i.e. selling a call or put that he or she does not already own. |
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All XYZ Calls & Puts = Option Class
All XYZ May 60 Calls = Option Series
Some final terms to review are option class and option series. Option class refers to all equity options of the same type, either calls or puts, covering the same underlying stock. For instance, all options on XYZ Corporation stock would be a class of equity options. Option series refers to all options of the same class having the same strike price, expiration month, and unit of trade. For example, all XYZ May 60 calls constitute an option series. Though we may not use these terms later in this class, you will see them elsewhere on this Web site, and in most books about options.
Now that we've got some basic option terminology in order, let's take a brief look at the option contract and the options marketplace. After this, we will get into more specifics about call and put equity option contracts; i.e. the ramifications of purchasing or writing them and the exercise/assignment settlement process.
Call and Put Specifics
Now that you know a little option terminology, and have some familiarity with the way the option marketplace works, let's take a closer look at call and put contracts: the ramifications of purchasing or writing them, what you pay for them (or sell them for), and option exercise and assignment.
The Equity Call and Put Contracts
We reviewed this earlier, but let's summarize the terms of standardized equity call and put option contracts.
Example 1:
One standardized American-style XYZ October 60 call option:
buyer |
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Writer |
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Example 2:
One standardized American-style XYZ September 75 put option:
Buyer |
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Writer |
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In the case of either a standard call or a standard put option, the owner of a long contract has the right to exercise the contract at any time up until the option's expiration. The option owner is in control of this. When and whether to exercise the contract is totally at the owner's discretion. Conversely, the writer of a (short) call or put option has a contractual obligation to fulfill the terms of the contract if assigned an exercise notice. This assignment can occur at any time until the option expires.
If a (long) call owner exercises that option, 100 shares of underlying stock will be purchased at the exercise price per share, from whomever is assigned on a short call contract with the same terms. If a (long) put owner exercises that option, 100 shares of underlying stock will be sold at the exercise price per share, to whomever is assigned on a short put contract with the same terms.
Long a Call or Put
While you are long (own) a call or a put, there are three basic alternatives in managing this position. First, you may exercise the option and buy or sell shares of the underlying stock. Again, it is your choice to do this or not. More information on how or when you might want to do this can be found later in this class in the chapter on Expiration, Exercise & Assignment.
Second, the option contract may be sold in the marketplace, if it has market value at the time. You might want to sell your call or put to either realize a profit, or to cut a loss on an unprofitable position. This sale, of course, must take place on or before the option's last trading day. A market quote (bid and ask price) for your contract may be obtained through your brokerage firm or an online quote provider. Any order to buy or sell an exchange-listed option must be placed through your brokerage firm.
Your third choice is to let the option expire worthless, if it has no market value on its last trading day.
Short Call or Put
While you are short (have written) a call or put, there are three basic alternatives in managing this position - two that you have some control over, one you do not. First, you may close out your short contract by making a closing purchase transaction. To do this, check for a market quote for an option with the same terms to see if there is an offer to sell one. If there is, you may enter a buy order for this contract through your brokerage firm. Once you buy back this short option, your obligations as defined by that contract are terminated. That is to say, if you were short a call you are no longer obligated to sell the underlying shares; if you were short a put you are no longer obligated to purchase the underlying shares. Once the short position is closed out, you are no longer vulnerable to an assignment on it the next trading day. Why would you want to close out a short option position? You may want to realize a profit, cut a loss, or for whatever reason no longer want its inherent obligations.
A second alternative is to let the option expire worthless, if it has no market value as expiration nears. Once expired, and without assignment, your obligations are terminated. The option ceases to exist. This alternative involves some market risk, however. As the end of trading for your expiring option approaches, an unexpected market move in the underlying stock may make you vulnerable to assignment at the last moment. Why is this a risk? If you are assigned unexpectedly, you will be making either a stock sale (in the case of a short call) or a stock purchase (in the case of a short put) that you might not have planned on.
A third alternative for the option writer is not really an alternative at all, it is possible assignment on the short contract. Again, as long as you have an open, short option position (from writing a contract), you may be assigned an exercise notice at any time up to and including its expiration. Your influence over not being assigned (if you do not wish to be) lies in the potential of closing out this short position before assignment is made.
Important Note to the Option Writer
Assignment notifications are generally made during the morning on a day the market is open. Check with your brokerage firm as to its procedures and timing for notifying its customers. Once you have been assigned, it is too late to close-out your position, whether you have been notified or not. When assignment is made, your obligations to buy or sell the underlying shares must be met that day. For more on when you might expect to be assigned on a short option contract, refer to the chapter of this class titled Exercise & Assignment.
Option Premium
We've talked a lot about buying and selling options, and the rights and obligations of option purchasers and writers, but what will an option really cost in the marketplace? The amount of money you pay for an option contract, or the amount you receive from its sale, is called the premium (or price). How are option premiums quoted? The bid and ask prices for standard option contracts disseminated from the exchanges are in dollars, or parts thereof, per underlying share. What does this mean? Let's look at a few examples.
Buying an Option
If you see an ask price (or "offer") for one standard call or put option as 2.50, this means $2.50 per share. You decide to buy this option at the quoted price of 2.50. Since standardized option contracts cover 100 shares of the underlying stock, it follows that you will really be paying $250.00 for this option, or $2.50 x 100 underlying shares = $250.00. If you were to buy 10 of these options, the total cost to you would be $2,500.00 ($250.00 per contract x 10 contracts). Currently, option premiums must be paid for in full; i.e., they cannot be margined. Once you purchase an option, this premium is in no way refundable, whether you exercise the option or not.
Selling an Option
Let's say you sell one standard option for a quoted price of 3.75. Just like an option purchase, this price is on a per share basis. The premium you receive for the contract would actually be $375.00, or $3.75 x 100 underlying shares = $375.00. If you were to sell 10 of these contracts, the total premium you would receive would be $3,750.00 ($375.00 per contract x 10 contracts). Understand that the seller keeps all premium received from an option's sale. If you are selling an option that you own, it is only logical that the premium received is yours to keep. An option writer also keeps the premium, whether or not he or she is assigned an exercise notice on the short contract.
Premium vs. Exercise Price
The premium does not affect the exercise price of the option. In other words, no matter what you pay or receive for a standard contract, you will still be purchasing or selling 100 shares of underlying stock at the exercise price per share when the option is exercised, and/or an assignment is made. However, the net cost, or net proceeds received, for these 100 shares is impacted by the premium, as you will learn later on in the chapter on Expiration, Exercise, and Assignment.
Profit?
How do you profit from an option transaction? Remember the adage: Buy low sell high. When you purchase any asset and then sell it, this saying applies, of course. However, options offer a simple twist on this adage: Sell high, buy low.
If you were to purchase an equity option for 2.50, or $250.00 per contract, and then sell it for 4.00, or $400.00, your profit would obviously be the difference: 4.00 - 2.50 = 1.50 or $150.00.
Conversely, if you purchase an option for 2.50, and sell it for 1.50, your loss would be the difference: 2.50 - 1.50 = 1.00 or $100.00. Pretty simple.
Think about writing an option, however. How do you profit from such a sale? Sell high, buy low. If you were to write an option for $5.00, the total premium you would receive would be $500.00. This cash would go into your brokerage account. If you were to buy it back (close it out) for 2.00, the premium you would pay would be $200.00. This is cash that would be transferred out of your brokerage account. The net of the two transactions would be $300.00 ($500.00 - $200.00) remaining in your account. This would be your profit. Profiting from a short sale of stock works the same way.
On the other hand, if you were to write this option for 5.00, and buy it back for 7.50, you would be paying 2.50 more to repurchase the option than the 5.00 you received from its sale. This 2.50, or $250.00 total, would be your loss. Losing money from a short sale of stock works the same way.
In either of these cases, however, this logic applies to a position that only involves calls or puts by themselves. When you begin to investigate various option strategies that involve multiple option positions, like spreads, or positions where options are either purchased or written in conjunction with a stock transaction, you will see that profit and/or loss calculation works a little differently. Any source you might refer to on option strategies, whether a publication or an online class, will cover this matter in detail.
Fluctuating Premium?
There are many factors that influence an option's market price. These factors are discussed in detail in this Web site's online class on Options Pricing. However, at this point let's summarize what is perhaps the most influential factor - the current market price of the underlying stock.
| In general, as the price of the underlying stock increases |
Taken by itself, an equity call purchase is considered bullish because this position will generally benefit from a bullish (up) move in the price of the underlying stock. Conversely, writing an equity call is considered bearish because this position will generally benefit from a bearish (down) move in the price of the underlying stock. (Remember, if you're short an option contract, you want the option premium to decrease.)
Puts work in the opposite manner. Taken by itself, an equity put purchase is considered bearish because this position will generally benefit from a bearish (down) move in the price of the underlying stock. Conversely, writing an equity put is considered bullish because this position will generally benefit from a bullish (up) move in the price of the underlying stock. (Remember, if you're short an option contract, you want the option premium to decline.)
Flexibility
When you begin investigating the numerous strategies in which you can use equity options in different ways, you will learn that there are different motivations for purchasing and writing options that may or may not reflect the above characteristics. A call or put purchaser might want to speculate - hopefully profit from a favorable move in the underlying stock and close out the position. On the other hand, he or she might actually want to acquire (in the case of a call) or sell (in the case of a put) underlying shares of stock at the options exercise price. A call might be written in conjunction with the ownership of an equivalent number of shares of underlying stock (100 shares per option contract), and this would be a slightly bullish position. Conversely, an investor might write a put contract in the hopes that the underlying stock price declines somewhat. This investor might want to be assigned and to purchase shares at the put option's strike price.
Don't be confused by this; we are simply addressing the basic qualities and features of long and short call and put contracts in this class, not necessarily the possible motivations behind the many option and/or stock strategies available to investors. At this point, understand that options are flexible financial tools. There are both advantages and disadvantages in using options for each particular financial or market situation that may arise.
More about Option Premium
Option values have a feature common to many derivative products - they can decrease, or decay, in value over time. This can either work to your advantage, or disadvantage, depending on your option position. Before we discuss this phenomenon, however, let's talk about the components that make up an option's premium.
In-the-money, At-the-money, Out-of-the-money
All equity options may be classified as being in-the-money, at-the-money, or out-of-the-money. These terms refer to a particular option's exercise price in relation to its current underlying stock price.
A call is considered:
- In-the-money when its exercise (or strike) price is less than the current underlying stock price.
- At-the-money when its excercise (or strike) price is the same as the current underlying stock price.
- Out-of-the-money when the strike price (or strike) is greater than the current underlying stock price.
A put is considered:
- In-the-money when its exercise (or strike) price is greater than the current underlying stock price.
- At-the-money when its excercise (or strike) price is the same as the current underlying stock price.
- Out-of-the-money when the strike price (or strike) is less than the current underlying stock price.
These are simple concepts when you understand the terms of call and put contracts. Why would an option contract be considered in-the-money? The term implies that there would be some benefit in exercising such an option at that moment. An option can be considered in-the-money because the owner who exercises it would pay (in the case of a call) or receive (in the case of a put) a better price (the exercise price) than by actually buying or selling shares of underlying stock outright in the stock market at the time. Let's consider some examples.
A call is considered:
in-the-money when its exercise (or strike) price is less than the current underlying stock price.
| XYZ Stock = 65.00 | |||||
| Calls | Puts | ||||
| Month | Strike | Premium | Month | Strike | Premium |
| September | 60 | 8.95 | September | 60 | 1.35 |
|
| 65 | 5.70 |
| 65 | 3.10 |
|
| 70 | 3.35 |
| 70 | 5.75 |
| October | 60 | 9.65 | October | 60 | 1.85 |
|
| 65 | 6.55 |
| 65 | 3.65 |
|
| 70 | 4.15 |
| 70 | 6.30 |
| December | 60 | 11.05 | December | 60 | 2.75 |
|
| 65 | 8.10 |
| 65 | 4.75 |
|
| 70 | 5.75 |
| 70 | 7.35 |
| March | 60 | 12.62 | March | 60 | 3.70 |
|
| 65 | 9.85 |
| 65 | 5.80 |
|
| 70 | 7.50 |
| 70 | 8.40 |
In-the-money call option:
Consider an XYZ September 60 call option, with XYZ stock currently at $65. Again, its owner has the right to purchase 100 shares of XYZ stock at $60 per share. Since the actual market value of XYZ stock is $65, it would be cheaper to exercise the call and purchase shares at $60 than to purchase shares outright at $65 on a stock exchange. Under these conditions, this call option is in-the-money by $5 ($65 current share price - $60 exercise price).
at-the-money when its exercise (or strike) price is the same as the current underlying stock price.
| XYZ Stock = 65.00 | |||||
| Calls | Puts | ||||
| Month | Strike | Premium | Month | Strike | Premium |
| September | 60 | 8.95 | September | 60 | 1.35 |
|
| 65 | 5.70 |
| 65 | 3.10 |
|
| 70 | 3.35 |
| 70 | 5.75 |
| October | 60 | 9.65 | October | 60 | 1.85 |
|
| 65 | 6.55 |
| 65 | 3.65 |
|
| 70 | 4.15 |
| 70 | 6.30 |
| December | 60 | 11.05 | December | 60 | 2.75 |
|
| 65 | 8.10 |
| 65 | 4.75 |
|
| 70 | 5.75 |
| 70 | 7.35 |
| March | 60 | 12.62 | March | 60 | 3.70 |
|
| 65 | 9.85 |
| 65 | 5.80 |
|
| 70 | 7.50 |
| 70 | 8.40 |
At-the-money call option:
With a current XYZ stock price of 65.00 (as above), all calls and puts with an exercise price if 65 are exactly at-the-money. While by definition such an option's exercise price and underlying market should be the same, you might see or hear reference to options whose exercise prices are close to the price of the underlying stock as being at-the-money. For instance: "At-the-money options trade more than in-the-money or out-of-the-money options." In this context, the observer is noting that contracts that are approximately at-the-money, give or take a few dollars, might have more trading volume than those that are considerably in-the-money or out-of-the-money.
out-of-the-money when the strike price (or strike) is greater than the current underlying stock price.
| XYZ Stock = 65.00 | |||||
| Calls | Puts | ||||
| Month | Strike | Premium | Month | Strike | Premium |
| September | 60 | 8.95 | September | 60 | 1.35 |
|
| 65 | 5.70 |
| 65 | 3.10 |
|
| 70 | 3.35 |
| 70 | 5.75 |
| October | 60 | 9.65 | October | 60 | 1.85 |
|
| 65 | 6.55 |
| 65 | 3.65 |
|
| 70 | 4.15 |
| 70 | 6.30 |
| December | 60 | 11.05 | December | 60 | 2.75 |
|
| 65 | 8.10 |
| 65 | 4.75 |
|
| 70 | 5.75 |
| 70 | 7.35 |
| March | 60 | 12.62 | March | 60 | 3.70 |
|
| 65 | 9.85 |
| 65 | 5.80 |
|
| 70 | 7.50 |
| 70 | 8.40 |
Out-of-the-money call option:
Consider an XYZ September 70 call option, with XYZ stock currently at $65. Again, its owner has the right to purchase 100 shares of XYZ stock at $70 per share. Since the actual market value of XYZ stock is $65, it would not make sense to exercise the call and purchase XYZ shares at $70 when the same shares could be purchased outright a $65 on a stock exchange. Under these conditions, this call option is out-of-the-money by $5 ($70 exercise price - $65 current share price).
A put is considered:
in-the-money when its exercise (or strike) price is greater than the current underlying stock price.
| XYZ Stock = 65.00 | |||||
| Calls | Puts | ||||
| Month | Strike | Premium | Month | Strike | Premium |
| September | 60 | 8.95 | September | 60 | 1.35 |
|
| 65 | 5.70 |
| 65 | 3.10 |
|
| 70 | 3.35 |
| 70 | 5.75 |
| October | 60 | 9.65 | October | 60 | 1.85 |
|
| 65 | 6.55 |
| 65 | 3.65 |
|
| 70 | 4.15 |
| 70 | 6.30 |
| December | 60 | 11.05 | December | 60 | 2.75 |
|
| 65 | 8.10 |
| 65 | 4.75 |
|
| 70 | 5.75 |
| 70 | 7.35 |
| March | 60 | 12.62 | March | 60 | 3.70 |
|
| 65 | 9.85 |
| 65 | 5.80 |
|
| 70 | 7.50 |
| 70 | 8.40 |
In-the-money put option:
Consider an XYZ September 70 put, with XYZ stock currently at $65. Again, its owner has the right to sell 100 shares of XYZ stock at $70 per share. Since the actual market value of XYZ stock is $65, it would be more profitable to exercise the put and sell shares at $70 than to sell shares outright at $65 on a stock exchange. Under these conditions, this put option is in-the-money by $5 ($70 exercise price - $65 current share price).
at-the-money when its exercise (or strike) price is the same as the current underlying stock price.
| XYZ Stock = 65.00 | |||||
| Calls | Puts | ||||
| Month | Strike | Premium | Month | Strike | Premium |
| September | 60 | 8.95 | September | 60 | 1.35 |
|
| 65 | 5.70 |
| 65 | 3.10 |
|
| 70 | 3.35 |
| 70 | 5.75 |
| October | 60 | 9.65 | October | 60 | 1.85 |
|
| 65 | 6.55 |
| 65 | 3.65 |
|
| 70 | 4.15 |
| 70 | 6.30 |
| December | 60 | 11.05 | December | 60 | 2.75 |
|
| 65 | 8.10 |
| 65 | 4.75 |
|
| 70 | 5.75 |
| 70 | 7.35 |
| March | 60 | 12.62 | March | 60 | 3.70 |
|
| 65 | 9.85 |
| 65 | 5.80 |
|
| 70 | 7.50 |
| 70 | 8.40 |
At-the-money put option:
With a current XYZ stock price of 65.00 (as above), all calls and puts with an exercise price if 65 are exactly at-the-money. While by definition such an option's exercise price and underlying market should be the same, you might see or hear reference to options whose exercise prices are close to the price of the underlying stock as being at-the-money. For instance: "At-the-money options trade more than in-the-money or out-of-the-money options." In this context, the observer is noting that contracts that are approximately at-the-money, give or take a few dollars, might have more trading volume than those that are considerably in-the-money or out-of-the-money.
out-of-the-money when the strike price (or strike) is less than the current underlying stock price.
| XYZ Stock = 65.00 | |||||
| Calls | Puts | ||||
| Month | Strike | Premium | Month | Strike | Premium |
| September | 60 | 8.95 | September | 60 | 1.35 |
|
| 65 | 5.70 |
| 65 | 3.10 |
|
| 70 | 3.35 |
| 70 | 5.75 |
| October | 60 | 9.65 | October | 60 | 1.85 |
|
| 65 | 6.55 |
| 65 | 3.65 |
|
| 70 | 4.15 |
| 70 | 6.30 |
| December | 60 | 11.05 | December | 60 | 2.75 |
|
| 65 | 8.10 |
| 65 | 4.75 |
|
| 70 | 5.75 |
| 70 | 7.35 |
| March | 60 | 12.62 | March | 60 | 3.70 |
|
| 65 | 9.85 |
| 65 | 5.80 |
|
| 70 | 7.50 |
| 70 | 8.40 |
Out-of-the-money put option:
Consider an XYZ September 60 put option, with XYZ stock currently at $65. Again, its owner has the right to sell 100 shares of XYZ stock at $60 per share. Since the actual market value of XYZ stock is $65, it would not make sense to exercise the put and sell XYZ shares at $60 when the same shares could be sold outright a $65 on a stock exchange. Under these conditions, this put option is out-of-the-money by $5 ($65 current share price - $60 exercise price).
On option's condition of being in-, at-, or out-of-the-money is dynamic. Because underlying stock prices fluctuate in the marketplace, the relative price relationship between an option's exercise price and the current market price of the underlying stock is constantly changing. Therefore, describing an option as in-the-money, at-the-money, or out-of-the-money should be used in the context of that moment in time. For instance, an option might be in-the-money at one moment, but after a move in the price of the underlying stock it might be out-of-the-money an hour later.
Intrinsic and Time Value
Option Premium = Intrinsic Value + Time Value
In-the-money Options: Premium = Intrinsic Value + Time Value
At-the-money Options: Premium = All TIme Value
Out-of-the-money Options: Premium = All Time Value
An option's premium consists of two components - intrinsic value and time value. The amount by which an option is currently in-the-money is called its intrinsic value. Equity options are generally worth (will trade for) at least their intrinsic value. However, because options have a lifetime, and the rights conveyed to their owners to buy or sell stock at the exercise price are good into the future, options will generally trade for more than this amount. Any premium amount in excess of intrinsic value is called time value.
XYZ Stock Price = $67.00
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What does time value represent? It reflects the amount of time you are "purchasing" or "selling" for your option position to become more profitable because of a favorable move in the underlying stock price. Logically, then, for options with the same exercise price, the more time until expiration the greater the time value component of an option's premium. Let's consider a couple of examples of in-the-money calls and puts.
| Current XYZ Stock Price = $62.00 | CALL | ||||
| In-The-Money Call Option | Total Premium | = | Intrinsic Value | + | Time Value |
| XYZ March 60 Call | $2.75 |
| $2.00 |
| $0.75 |
| XYZ June 60 Call | $4.25 |
| $2.00 |
| $2.25 |
| XYZ September 60 Call | $6.50 |
| $2.00 |
| $4.50 |
| Current XYZ Stock Price = $62.00 | PUT | ||||
| In-The-Money Put Option | Total Premium | = | Intrinsic Value | + | Time Value |
| XYZ March 65 Put | $3.90 |
| $3.00 |
| $0.90 |
| XYZ June 65 Put | $5.65 |
| $3.00 |
| $2.65 |
| XYZ September 65 Put | $8.25 |
| $3.00 |
| $5.25 |
All of these options are currently in-the-money and have a fixed intrinsic value amount. As you can see by these hypothetical trading prices, the amount of time value increases with the amount of time until expiration.
By definition, only in-the-money options have intrinsic value. The prices at which they trade generally have both intrinsic value and time value components. What about at-the-money or out-of-the-money option contracts? They have no in-the-money amounts, so their premiums consist entirely of time value. As it is the time value portion of the total premium that increases with time, at- and out-of-the-money option premiums will also generally increase with increasing time until expiration.
Note: The time premium portion of an option's premium can be affected by factors other than the passage of time; e.g., the underlying stock's volatility, interest rates, and dividends. However, discussion of these factors is beyond the scope of this particular class on Option Basics. For more about this, please review this Web site's on-line class on Option Pricing.
Another phenomenon involving time value is that as calls or puts become more in-the-money, the time value portion of its premium decreases relative to the total premium. This makes sense when you remember what time value represents - time for your long option to become more in-the-money and hopefully more profitable. As options become more in-the-money, the greater the likelihood that they will expire in-the-money, and less the time remaining until expiration will be "worth." As this happens, the option's total premium should increase, but the proportionate amount of time value should decrease.
Exercise Price vs. Option Premium Let's look at a "montage" of all option prices on XYZ stock and observe some characteristics of option premiums vs. strike prices vs. time until expiration. Tables like this are commonly found on many brokerage firm Web sites now.
| Call |
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- As call exercise (strike) prices increase, premiums will decrease.
- As call exercise (strike) prices decrease, premiums will increase.
For any given expiration month, as call exercise prices increase, the more out-of-the-money those options currently are. The more out-of-the-money an option currently is, the less you will pay for it. This is a general option rule.
| Put |
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- As put exercise (strike) prices increase, premiums will increase.
- As put exercise (strike) prices decrease, premiums will decrease.
For any given expiration month, as put exercise prices decrease, the more out-of-the-money those options currently are. The more out-of-the-money an option currently is, the less you will pay for it. This is a general option rule.
Time Decay
An important characteristic of an option premium's time value portion is that it generally decreases over time. This phenomenon is referred to as time decay, and occurs with both call and put premiums. Remember that the time value portion of an option's premium reflects the amount of time remaining until the option's expiration - the time during which your option position has to become more profitable. Let's consider a specific option scenario:
Current XYZ stock price = $62.50
XYZ may 60 call trading at $5.75
Let's review. Today, you buy this May 60 call option which is trading for 5.75 (or $575.00 total premium per contract). As the exercise price is 60, and the current value of the underlying stock is 62.50, this call is in-the-money (exercise price less than underlying stock price) by 2.50 (62.50 stock price - 60 exercise price). This 2.50 represents its intrinsic value (the in-the-money amount).
| Total premium | - | intrinsic value | (if in-the-money) | = | Time value |
| 5.75 | - | 2.50 |
| = | 3.25 |
The call's total premium, however, is currently 5.75. The amount by which the total premium (5.75) exceeds the intrinsic value (2.50) is the time value portion, or 3.25.
Time Decay (Cont.)
Let's consider an exaggerated market scenario: XYZ stock does not change from $62.50 between now and May expiration. This time premium amount of 3.25 will decay, or decrease, as May expiration approaches. Generally speaking, the rate at which it decays increases somewhat the closer we get to expiration. When an option expires, all time premium will have decayed away, and the option will be worth its intrinsic value. This is another general rule about options.
Remember that May expiration is technically the Saturday after the third Friday in May, but that Friday is the last day this May 60 call will actually trade, and the last day on which you may exercise the call. If XYZ stock is at $62.50 as the market closes on Friday, this May 60 call will be worth its intrinsic value, or 2.50. There is no time value remaining. If you were to sell this call at the close of trading on May expiration for its intrinsic value, you would have lost an amount equal to this original time value of 3.25, or $325.00 per contract.
Time Decay (Cont.)
The passage of time is only one of many factors that affect an option's price, but worth noting here. A change in one or several of these other factors might have overcome this time decay phenomenon in our case, and might have resulted in a profitable scenario. For instance, had the price of XYZ stock increased dramatically to $70 at May expiration, its intrinsic value would have been 10.00, considerable more than the 5.75 paid for the call. On the other hand, had the price of XYZ stock dropped dramatically after the call's purchase, it would have become out-of-the-money and possibly have no market value at all. In this case, the effect of time decay might seem insignificant.
Is time decay always a bad thing? No. If you are purchasing calls and puts, this phenomenon is not to your benefit, as you have seen. However, if you are writing options, i.e. short the contracts, time decay can work to your benefit. Remember sell high, buy low? When you are short option contracts you want time decay - you want the total option premium to decrease to make a profit. In many different option strategies you can write options in the hope that they will decrease in value.
As stated earlier, there are other factors that affect an option's premium. The singular effect of a change in any of these factors may be good or bad for your option positions, and the sum effect of changes in some or all of these changes may be good or bad. Option pricing is a dynamic process. The marketplace will account for all of these factors as they change over time, and price options accordingly. For more discussion about what these factors are and how they can affect your option positions, refer to this Web site's online class on Option Pricing.p
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