PrintPut and call options are legal contracts that give the owner the right to sell or buy a specified amount of an underlying asset at a specified price for a specified time. Unlike common stock investments, option investments have finite lives.
You can find more information about Options Basics on this Options Basics Tutorial. Also, the Chicago Board of Options Exchange has very useful information about various types of options. If you are interested, there are some very useful educational materials in the form of free online courses provided on the Chicago Board of Options Exchange website.
Here are some common terms in Option contracts:
Call: An Option contract that gives the holder the right to buy the underlying security at a specified price for a certain fixed period of time.
Put: An Option contract that gives the holder the right to sell the underlying security at a specified price for a certain fixed period of time.
Holder: The purchaser of an option.
Write: To sell an option.
Premium: The price of an option contract, determined in the competitive marketplace, which the buyer of the option pays to the option writer for the rights conveyed by the option contract.
Strike Price: The stated price per share for which the underlying security may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.
Expiration date: The day on which an option contract becomes void. For stock options expiring prior to February 15, 2015, this date is the Saturday immediately following the third Friday of the expiration month. For stock options expiring on or after February 15, 2015, this date is the third Friday of the expiration month. Brokerage firms, however, may set an earlier deadline for notification of an option buyer's intention to exercise. If Friday is a holiday, the last trading day will be the preceding Thursday.
Intrinsic value: The value of an option if it were to expire immediately with the underlying stock at its current price; the amount by which an option is in-the-money. For call options, this is the difference between the stock price and the striking price, if that difference is a positive number, or zero otherwise. For put options, it is the difference between the striking price and the stock price, if that difference is positive, and zero otherwise.
In-the-money: A term describing any option that has intrinsic value. A call option is in-the-money if the underlying security is higher than the striking price of the call. A put option is in-the-money if the security is below the striking price.
Out-of-the-money: A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the-money if the strike price is less than the market price of the underlying security.
Time Value: The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.
Index: A compilation of the prices of several common entities into a single number.
Index Option: An option whose underlying entity is an index. Most index options are cash-based. A “common stock index” is a measure of the value of a group of stocks. And it can be calculated by applying simple or weighted average of price to a group of stocks. An index responds only to price movements in stocks on which it is based. No index gives a true reflection of the total stock market. When an index option is exercised, the exercise is settled by payment of cash, not by delivery of stock.
Example 12-1
Assume that in January the price of XYZ common stock is $49 per share. A person acquires an April XYZ call option at a $50 strike price for a premium of $2 per share. In February the price of XYZ stock has risen to $55 per share.
The call price is $6 per share when it is sold. Calculate the profit or loss from these call transactions.
Solutions
Buying the call option for $2 per share multiplied by 100 shares equals $200 cost plus commission. Selling the call option for $6 per share multiplied by 100 shares equals $600 income minus commission. Neglecting commissions, the call transaction profit = $600 - $200 = $400. Note that it is the option price and not the underlying asset stock price that is used in determining profit and loss on options. We are interested in the underlying asset stock price movement because it is the driving force that caused the call price to increase and give the investor the $400 profit.
Example 12-2
Following Example 12-1, assume an April XYZ put option at a $50 strike price for a premium of $3 per share. The put price is $0.5 per share when it is sold. Calculate the profit or loss from these put transactions.
Solutions
Buying the put option for $3 per share multiplied by 100 shares cost $300 plus commission. Selling the put option for $0.5 per share multiplied by 100 shares equals $50 income less commissions. Neglecting commissions, the put transaction loss or negative profit equals $50 - $300 = -$250. If the stock price had dropped from $49 to $45 per share instead of rising to $55 per share, the put option transaction would have generated a profit and the call transaction would have generated a loss.
Italicized sections are from Stermole, F.J., Stermole, J.M. (2014) Economic Evaluation and Investment Decision Methods, 14th edition. Lakewood, Colorado: Investment Evaluations Co.