What is an Option?

In 1973, the Chicago Board Options Exchange began to offer what has become the most popular derivative in the world. Their product is called an option, which is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date (Investopedia). From that day on, the face of the trading world changed. It may be difficult for the average retail investor to cobble together $1000 to buy a share of PLCN and expect reasonable gains, but now all of a sudden you can profit from its price action by buying a $75 call! It essentially turns even the largest of companies into a penny stock! 

For the classical investor, options can be intimidating. You basically own an agreement to own something, which in itself has little value. In addition, if you don’t understand all the variables that go into understanding what you have, you can easily lose money and become disenchanted. Lucky for you, I’m here to decode this mysterious but highly lucrative product for you. 

What is an option's value?

The classic stock option agreement is for 100 shares of a stock at a certain price (called a strike price) by a certain time (expiration date). These options are sold at a price completely determined by the options free market; supply and demand. That price is split into two parts… intrinsic value and extrinsic value. Intrinsic value is the amount the option is worth if exercised immediately, and extrinsic value (also known as premium) is the amount you expect to be realized by the expiration date (otherwise you wouldn’t buy it!). As an example, PCLN is currently trading at $1043. A Feb. $1000 call option is selling for $75. The intrinsic value is $43, the extrinsic value is $32. If an option has any intrinsic value, it is called “in-the-money” (ITM). Without any intrinsic value, it is simply “out-of-the-money” (OTM). 

Can I play both directions with options?

Absolutely! You can buy a bullish option known as a call. This would be an agreement to buy 100 shares of a stock at a certain price. You can also buy a bearish option known as a put. This is an agreement to sell 100 shares of a stock at a certain price. Furthermore, you can also sell calls and puts! So selling a call option is a bearish move, and reverse for a put. I will explain the advantages to each of these choices in a later article. 

When can I exercise my option?

Exercising an option means to put the agreement into effect. There are two types of exercising options, American style and European style. American style means you can exercise whenever you want, as long as it is before the expiration date. European style options settle on the expiration date no matter what. American style options are done at the buyer’s will, so if you sold a put and the stock is above the strike price, you cannot just “exercise” it and collect your premium before the option is in the money. However, you can sell your obligation at the price the market dictates in the secondary market. This is the route most buyers take. In fact, according to the Options Clearing Corporation (OCC), in 2006 only 17% of options actually were exercised. (see table below). Stock options are typically American style. If you plan on holding options for a long time it would be good to know what kind of option you are holding. The last thing you want is to wake up one Monday short 100 shares of a call option you sold! 

When the expiration date comes, ITM options are automatically exercised and OTM options expire worthless. On expiration day, options are either “AM-settled” or “PM-settled”. An AM-settled option’s settlement price is the opening price on the next trading day. PM-settled means the settlement price is the closing price of the stock on expiration day (technically 15 minutes after the close, actually). The typical monthly stock option is “AM-settled” on the third Friday of the month, and weekly stock options are typically “PM-settled” on Friday. Most of the time I don’t advise holding an option until expiration for reasons I’ll discuss in later articles, but this is important to know. 

When can I trade my option?

Almost all options are traded during market hours only! This means there is risk in holding options overnight. This is extremely important when trading options, as you could stand to lose a lot of money without the ability to mitigate losses if something happens in the after-market or pre-market. 

What is the impact of dividends on my option?

Technically there is no impact of dividends on an option itself.  There are some impacts, however.  First, theoretically, when an equity goes ex-dividend the stock is supposed to decrease by the amount of the dividend. This is sometimes priced into the options, sometimes it is not.  

Further, with American-style options, when holding options in the money, sometimes institutional investors will exercise the options in order to capture the dividend in an arbitrage that is close to risk-free.  The moral of that story is, do not hold short ITM calls into an ex-dividend date.  

Summary

Options are a fantastic vehicle for anyone who wants to trade future movement of stocks, or markets in general. They are tremendously flexible and have the capability to accelerate your gains while controlling your risk. It is important to know what you are buying, and to know what you are getting into. 

Hopefully this article helped you understand your option contracts a little better. In future articles, I will talk about risk management with options, the variables involved with options, I’ll introduce you to the “greeks”, and common option strategies. This will lay the groundwork for my mission as The Wizard of Ops, which is to optimize your trading strategy.