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 U.S. stock exchanges are termed equity securities. What is an option, then? In a word, an option is actually a contract. Unlike stock, however, an option does not convey to the purchaser ownership in anything. Instead, an option contract conveys a right to its owner to buy or sell the underlying financial instrument on which it is based. The options we will be talking about in this class are based on equity securities, or stocks, and are thus referred to as "equity options." There are "regular" options that have expiration dates up to 9 months from the day they are issued, and there are long-term options that have expirations of up to three years called LEAPS®. When either of these types of equity options is exercised, a physical delivery of shares of its underlying stock from one party to another takes place. We'll see how this works a little later.
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 U.S. marketplace.
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 U.S. securities exchanges that specialized in the listing and trading of equity options, and with the standardization of their contract terms. The creation of The Options Clearing Corporation was key to this process.
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Today, there are many options exchanges both in the United States and around the world. The environments in which listed options are traded vary from an open outcry, trading floor-based environment to the totally electronic, computer network environment. No matter the place or the method, prices are quoted and transactions are made in a marketplace open to individual investors and option professionals alike, just as any other regulated U.S. securities industry.
An option is a contract between a buyer and a seller. The option is
connected to something, such as a listed stock, an exchange index, futures
contracts, or real estate. For simplicity, this article will discuss only
options connected to listed stocks.
Just to be complete, note that there are two basic types of options, the
American and European. An American (or American-style) option is an option
contract that can be exercised at any time between the date of purchase and
the expiration date. Most exchange-traded options are American-Style. All
stock options are American style. A European (or European-style) option is
an option contract that can only be exercised on the expiration date.
Futures contracts (i.e., options on commodities; see the article elsewhere
in this FAQ) are generally European-style options.
Every stock option is designated by:
- Name of the associated stock
- Strike price
- Expiration date
- The premium paid for the option, plus brokers commission.
The two most popular types of options are Calls and Puts. We'll cover
calls first. In a nutshell, owning a call gives you the right (but not the
obligation) to purchase a stock at the strike price any time before the
option expires. An option is worthless and useless after it expires.
An
option is a contract to buy or sell a specific financial product officially
known as the option’s underlying instrument or underlying interest. For
equity options, the underlying instrument is a stock, ETF, or similar
product. The contract itself is very precise. It
establishes a specific price, called the strike price, at which the contract
may be exercised, or acted on prior to the expiration date. When an option
expires, it no longer has value and no longer exists.
Options come in two varieties, CALLS and PUTS, and you can buy (hold or go
long) or sell (write or go short) either type. You make those
choices - whether to buy or sell and whether to choose a CALL or a PUT -
based on what you desire to achieve as an options investor.
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A CALL is the right to buy 100 shares of stock at a fixed price per share,
any time between purchase of the call and the specified deadline in the
future. The time is limited. As a long call buyer,
you acquire the right to buy the stock and as a short call seller, you grant
the right to someone else. A short call seller (writer) must
also be willing to deliver or has the obligation to sell 100 shares at the
strike price if the long call buyer (holder) exercises the option.
A PUT is the opposite of a call. It is a contract granting the
right to sell 100 shares at a fixed price per share and by a specified
expiration date in the future. As a long put buyer, you acquire
the right to sell the stock and as a short put seller, you grant that right
to someone else. A short put seller (writer) must also be
willing to acquire or has the obligation to buy 100 shares at the strike
price if the long put buyer (holder) exercises the option.
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