Option trading can serve a variety of different purposes. Options can hedge a risk, generate income or provide a vehicle for speculating on a stock, a commodity or an equity index. Thanks to the public market for listed options established by the Chicago Board Options Exchange (CBOE) in 1973, individual investors can trade options.
According to the Options Clearing Corporation publication Characteristics and Risks of Standardized Options, an option is a contract that gives the purchaser the right to buy or sell a stock or other security for a specified price before its expiration date. Options fall into the category known as derivatives because they derive their value from the price of an underlying security. A
lthough the particular terms of an option contract and demand and supply forces within options markets also determine option pricing, the price of the security subject to the option is an essential component of its price (also called the option premium).
A call option gives its owner the right to buy a stock in the future for a purchase price specified in the option contract. If price of the underlying security rises above the option exercise price before the option expires, then the option holder may be able to sell the option for a profit or acquire the underlying asset at a discount.
Put options give the option holder the right to sell (or put) a security to the option seller (also known as the option writer) for a predetermined price before the option expiration date.
Option contracts specify the price for which the option holder can buy (call) or sell (put) the underlying security. The option exercise price is known as the strike price. Call options with strike prices below the underlying asset’s market price and put options with strike prices above the underlying asset’s market price are called “in the money.” Call options with strike prices above the underlying asset’s market price and put options with strike prices below the underlying asset’s market price are “out of the money.” At the money options have strike prices approximately equal to the underlying security’s market price.
Unlike shares of stock, an option contract has a limited lifespan. Most options expire within nine months from the date they begin trading. However, investors can buy LEAPS for some stocks, which are options with durations up to three years.
Option traders can close out a position in one of three ways. They can take no action and let the option expire worthless, sell the option before it expires, or exercise the option.
The CBOE operates a public market for trading option contracts. Options listed on the CBOE have standard terms to facilitate market making. Listed options expire on the third Friday of the expiration month. For example, a September 30 option would expire on the third Friday of September; 30 identifies the strike price rather than the expiration date.
Public option markets list price quotes in per share terms. Each option contract includes 100 shares. If the ask (selling) price for an option is quoted as $1.25, then the purchase price (also called the premium) for that option contract will equal $125 (100 x $1.25).