Purchasing an option gives you the right (but not the obligation) to buy or sell a specific asset at a specific price by a specific time. The value of an option is related to that underlying asset; therefore, options belong to a class of securities known as derivatives. Options contracts are written on many different types of securities, including:
- Common stock
- Government debt
- Stock or other indexes
- Commodity futures contracts
- Foreign currencies
- Interest rate futures
- Precious metals
Buying an option contract is very different from buying the asset itself. For one thing, an option has an expiration date. As an option buyer, or holder, you have a deadline for exercising your right to buy or sell (known as exercising the option). If you choose to exercise your option, the seller (known as the option’s writer) must either buy from you or sell to you the specified asset. (Which one it is depends on the type of option you hold; see below). However, if you don’t exercise your option within the allotted time, your option expires and you lose the money you paid for it.
An option also sets the price for which you can buy or sell its underlying asset. That price, known as the strike price, is valid until the option expires, regardless of what the asset is selling for in the marketplace.
Example(s): You hold an option to sell 100 shares of Company A stock. Your option’s strike price is $40. If you exercise your option before it expires, the writer of the option must buy those shares from you and pay $40 a share, even if the shares are trading at $30. If you had an option to buy those shares with a $40 strike price, the option writer would have to sell them to you at $40, even if they were trading for $50.
The price paid for an option is referred to as its premium.
What kinds of options are there?
There are two fundamental kinds of options: calls and puts. You can buy or sell either kind, but let’s look first at how each works if you buy an option.
- Call: An option to buy the underlying asset, as in the example above, is known as a call. When you buy a call, you as the holder have the option of calling the asset away from its owner, paying the price specified in the option contract. In a sense, buying a call is a bit like putting down a deposit on a house. The deposit ensures that you have the right to buy the house, but if you decide not to go through with the purchase, you forfeit the deposit. (Unlike a house deposit, however, the price of an option doesn’t get applied toward the cost of exercising the option if you choose to do so).
- Put: An option to sell an asset at a specific price is known as a put option. When you buy a put, you as the holder have the right to “put” the asset out to the option’s writer (seller), who must buy it from you at the strike price. Puts are often bought for much the same reasons as car insurance. One of the reasons drivers buy insurance is to help themselves recover financially in case their car gets damaged. Investors often buy puts to help themselves recover in case the price of their option’s underlying asset goes down. If the price doesn’t drop and the option isn’t exercised, the put seller keeps the premium, just as the insurance company would keep your insurance premium.
Conversely, when you write (sell) an option, instead of getting the right to own or sell the underlying asset, you’re agreeing to deliver the asset to the option holder at the strike price whenever the holder demands it.
Example(s): You hold 100 shares of Company A stock; the current price is $40 a share. You might sell a call option at a strike price of $50. If the stock’s price never rises above $50 a share during the option term, you still have your stock holdings plus the premium paid to you as the seller.
However, in most cases, options traders never actually intend to buy or sell the underlying asset, but hope to profit from the option itself.
What affects the price of an option?
Although an option is essentially a contract between you and a second party, you may also be able to sell your option to a third party, just as you might any other security (though there’s no guarantee that you’ll find a buyer). If you sell the option before the expiration date instead of exercising it, you may recognize a profit or loss. The price or fair market value of the option will depend on several factors:
The relationship between the option’s strike price and the current market value of the underlying instrument
An option holder would typically exercise an option when it is “in the money”–in other words, when its terms favor the option holder. If an option’s strike price is equal to the current market price, the option is said to be “at the money.” If it is unfavorable to the option holder, it is “out of the money.”
A call option is considered in the money when the option’s strike price is less than the current market price of the underlying security (because the call option holder can then exercise the option to buy the security at the strike price and resell it at a profit). Similarly, a put option is considered to be in the money when the option’s strike price is greater than the underlying asset’s current market value (because the put option holder can exercise the option and sell the asset for more than it would otherwise bring on the market).
Example(s): You want to buy a call option for a security that tracks the Nasdaq 100 Index. The security is at $42, but you believe it will be trading 10 points higher by the same time next year. You’re considering two call options, each of which expires in exactly one year. One has a strike price of $32, the other a strike price of $36. They’re both currently in the money, because if you exercised them right away and bought the underlying shares at the strike price, you could sell them immediately for $42 each on the open market. The first option would probably cost more, because its potential for profit would be greater. An option that was out of the money—for example, an option with a strike price of $44—would be less expensive, because the price of the tracking security might never reach $44 during the year—in which case your option would expire worthless.
As an option moves deeper into the money (in other words, as its terms become more favorable to its holder because of changes in the underlying security’s market price), the option’s premium may increase. If that’s the case, an option holder might be able to sell the option to a third party for more than its original price and realize a profit on the option transaction.
The volatility of the underlying instrument
The greater the price swings of the underlying instrument, the greater an option’s potential for coming into the money. Because of that greater potential, its premium would be higher than the premium for an option on a less volatile security, all other factors being equal.
The time left until the option expires
Other factors being equal, options decrease in value as the expiration date nears. That’s because if an option isn’t exercised or sold, it loses all value when the expiration date arrives.
Caution: If you’re considering options as an addition to your portfolio, you should bear in mind that they generally require careful research and attention to market movements. Essentially, your investment depends on your being right not only about whether the value of the underlying instrument will rise or fall, but when that will happen and by how much. As a result, a stock option is likely to involve greater consideration and care than investing in the stock itself, and is not suitable for all investors.
Options and their underlying investments
Equity or stock options are the most common type of option. Their underlying securities are common stocks traded actively on the stock market. However, the option contracts themselves are issued not by the corporations but by the Options Clearing Corporation (OCC), which operates under the jurisdiction of the SEC and the Commodities Futures Trading Commission. Typically, a stock option covers 100 shares of a stock, and investors may buy multiple option contracts for the same stock. If there is a stock split or stock dividend, the option is adjusted to reflect the change. Unlike shares of stock, the number of options for a given company’s stock is unlimited. Also, options do not confer voting rights or dividends on their holders. Typically, equity options are relatively short-term investments; with the exception of LEAPS (see below), options last nine months or less.
Index options allow you to invest in the indexes that track the movements of securities markets. Although you cannot actually buy or sell the index itself, you can purchase index options as a way of speculating on changes in the market (or market segment) that the index represents.
Short for Long-term Equity AnticiPation Securities, LEAPS are essentially equity or index options with a longer-term focus. The expiration date for a put or call LEAP can be as much as three years in the future. Otherwise, they function in much the same way as ordinary equity or index options, though they are not available on all stocks. They were developed by the Chicago Board Options Exchange (CBOE).
Interest rate options
Interest-rate options are options on government debt securities, such as Treasury bills and notes. Like stock options, interest-rate options respond to changes in the value of the underlying security. However, interest-rate options differ from stock options because they’re directly tied to changes in the interest rates of the underlying securities. As rates go up, the values of the securities underlying the options go down, and vice versa. Because of the high prices of the underlying securities, interest-rate options usually require large initial investments. Consequently, most investors in this type of option are institutions rather than individuals.
Foreign currency options
Foreign currency options are options to buy or sell foreign currency, such as British pounds or Japanese yen. Just as the price of the stock underlying a stock option contract will vary and cause the value of the stock option to change, so currency exchange rates will fluctuate and determine the value of the foreign currency option at a given point in time.
Futures options allow you to speculate on fluctuations in the price of a futures contract–a contract for the future delivery of a specific commodity, such as precious metals, agricultural products, or even financial products.
Other optionable investments
Options also can be issued for American Depositary Receipts (ADRs), exchange-traded funds (ETFs), and Holding Company Depositary Receipts (HOLDRs).
Why do investors buy options?
There are many reasons investors might decide to buy options, and many strategies investors can implement with them.
Options allow you to leverage your investment capital
Buying an option is typically less expensive than buying 100 shares of a stock outright, though it includes none of the benefits of direct stock ownership, such as the right to vote or receive dividends. For example, you might buy a call option if you believe the market price of the underlying stock will rise above the option’s strike price. If it does, you could then exercise the option, buy the stock at the strike price and immediately sell it at the higher market price, thereby realizing a profit. Conversely, if you believe the market price of a stock will decline, you could buy a put option. If the price of the stock falls below the put option’s strike price, you could buy the stock at the lower market price, then exercise your put option and sell the stock for a profit at the higher strike price.
Options may help you hedge investments you already have
If you already own shares of a stock, options can help minimize a potential loss if the stock’s price drops before you sell your shares. For example, if you own a large amount of stock and are worried its price might decline, you could buy put options that would give you the right to sell some of that stock at a given price, even if its market price falls.
Options can help you diversify your investment portfolio
Depending on your strategy, you can use the risks and potential rewards of options to offset and balance risks from other investments.
Writing options may produce additional income from an investment you already own
When you write (sell) a call option, the option’s buyer pays you a premium. If that buyer doesn’t exercise the option, you don’t have to sell those securities, and you keep the premium. As long as you’re prepared for the possibility you might have to buy the underlying shares at the strike price, you can generate income by writing put options.
Option transactions also can involve substantial risk, and are not suitable for all investors. Some options strategies are riskier than others, and you should be fully aware of any potential for loss before investing. A booklet titled “Characteristics and Risks of Standardized Options” must be furnished to an investor in order for him or her to begin trading options; it also is available online from the Options Clearing Corporation (OCC) at www.theocc.com.
The time frame for trying to profit from your option is limited, and you could lose your entire investment
If you don’t exercise or sell your option by the expiration date–for example, if your forecast about the direction, size, or timing of market changes is wrong–you’ll lose the entire amount of the premium you paid for it. While the loss of the premium might be less than the loss you might have incurred had you bought the underlying asset directly, it would still represent a total loss of your investment in the option.
Also, all other factors being equal, the value of an option falls over time as the expiration date nears. Even if you attempt to sell your option to a third party before it expires, you may suffer a loss, especially if the option isn’t in the money.
Option writers can suffer substantial losses if the option is exercised at an inopportune time
As an option writer, you have no control over when the option is exercised. If you’ve written a call option that’s exercised, you may have to sell stock at a strike price that’s lower than the current market price. That would cost you the profit you could have realized had you been able to sell the stock at the market rate. If you’ve written a put and the holder exercises it, you may have to buy the underlying stock at a strike price that’s higher than the stock’s current market price. Depending on the size of those price differences, your losses (represented by either lost profit resulting from exercised calls, or lost price savings on puts) could be significant.
Trading costs for options can reduce any profit you make
Because there may or may not be a ready market for your option, the spread–the difference between the bid and ask prices of an option–can represent a greater percentage of your investment than it would for the underlying security. Even if your option is in the money, any profit might be reduced or offset by the costs involved.
There’s no backing out of an option contract
Once you’ve agreed to buy or sell an option’s underlying asset, you can’t change your mind. You may be able to sell your option to another investor, but as long as you hold the option, you’re obligated to fulfill that contract whenever the other party demands that you do so, even if you don’t own the asset at the time.
Options require attention to market movements
If you have bought an option, you need to monitor the price of your option’s underlying asset and be aware of whether and when it is profitable for you to exercise it. If you’ve sold an option, you need to know whether you’re at risk of a loss from having to fulfill that agreement by buying or selling the underlying asset.
How are options quoted?
Option listings include a symbol denoting the underlying security, as well as the option’s expiration date, strike price, and whether it is a put or a call. An option to buy 100 shares of Microsoft for $50 a share before December of the current year would be referred to as the Microsoft December 50 call. Each option has its own unique symbol.
A list of current premiums, expiration dates, and strike prices for both call and put options for a single security is referred to as an option chain. The quote is a per-share price; since options are typically for 100 shares, an option’s cost can be calculated by multiplying the quoted price times 100.
How are options traded?
Options on stocks and other securities trade on over-the-counter markets and exchanges, including the American Stock Exchange, the Chicago Board Options Exchange, International Securities Exchange, New York Stock Exchange Arca, and regional stock exchanges.
A listed option contract is one that is traded on a national options exchange. In order to qualify for trading on an options exchange, the security underlying the option contract must meet that exchange’s listing requirements. The OCC standardizes options contracts, issues options, and ensures that the contracting parties live up to the terms of the contract. Listed equity options must be exercised before 5:30 p.m. on the third Friday of the option’s expiration month; otherwise, they expire worthless the next day. Options traded over-the-counter, in contrast, often have negotiated or non-standard terms.
Income tax considerations
Equity options may be subject to capital gains or losses under any of the following conditions:
- The option expires
- You sell the option to another holder
- You exercise the option
If the option expires before being exercised, it loses its value. As the option holder, you’ll have sustained a capital loss equal to the option premium, or the price you paid for the option. (Whether the loss is short-term or long-term depends on how long you’ve held the option.) Conversely, the option writer has a short-term capital gain equal to the same amount.
If you resell an option to another party before it expires, then you generally have a capital gain or loss equal to the difference between the option premium you paid (plus any commissions) and the premium paid to you by the new option holder (less any commissions incurred in the sale). Again, whether the gain is long-term or short-term depends on how long you’ve held the option.
If you exercise a call option, you compute capital gain or loss based on the difference between your cost basis and the amount you received from the subsequent sale of the stock. Your cost basis will be the option premium plus the amount you paid to purchase the stock at the strike price (plus any commissions paid). The option writer computes the gain realized on the sale of the stock by adding the premium received for the option to the amount that the option buyer paid for the stock at the strike price.
If you exercise a put option, you calculate capital gain or loss by deducting your cost basis (the option premium you paid and the amount you originally paid for the stock at the market price, plus any commissions) from the amount you received from selling the stock at the strike price. The put option seller calculates any capital gain or loss as the difference between the stock’s cost basis (the strike price paid for the stock less the option premium received) and the amount received for the subsequent sale of the stock to someone else.
Caution: Special tax treatment applies to transactions that involve nonequity options.
Caution: The tax issues surrounding options are very complicated, and are described here only in the most general terms. Consult a tax professional for details.