Introduction to Options

Introduction to Options

Before getting into covered calls, I have to cover some option basics. You will never master option trading until you are fluent in the option basics. This article will of course mostly discuss call options, since put options are not part of the covered call writing strategy. So let’s get started!

What is an Option?

An “option” is a standardized contract originated by the Options Clearing Corporation (OCC) that is exchange-listed. A stock option is the legal right, but not obligation, to buy (calls) or sell (puts) shares of a specified stock, which is known as the underlying stock, for a fixed time and at a fixed price. Stock options thus have two main characteristics:

Fixed price: an option gives holder the right to buy or sell at a fixed price. This price is known as the exercise price or strike price (or just “strike”).

Limited life: an option is good for only a specific period of time, then expires. If it expires without being exercised, it is said to “expire worthless.”

The Two Types of Options:

  • Calls (the right, but not the obligation, to buy the underlying stock)
  • Puts (the right, but not the obligation, to sell the underlying stock)

Figure 2.1

Buying and Selling Stock Options
Action Status Call Option Put Option
Buy LONG Holder has the right, but no obligation, to buy 100 shares Holder has the right, but no obligation, to sell 100 shares
Sell SHORT Seller has the obligation to sell 100 shares if calls are exercised Seller has the obligation to buy 100 shares if puts are exercised


Underlying stock
– These are the shares of stock that underlie (are subject to) a stock option. The underlying stock also can be an Exchange-Traded Fund (tracking stocks), which are covered further on.

Key Features of Options

Option Contract – Each exchange-listed (listed) call or put contract normally covers 100 shares. The only exception would be for a stock split or reverse split, merger or other corporate recapitalization, which can result in adjustment to the terms of option contracts (explained below). There are over-the-counter options, but they are a different subject and not covered here.

Option Trading – Standardized option contracts are exchange-listed and traded on the five different US option exchanges.

Expiration – Stock options (equity options) expire on the Saturday following the 3rd Friday of each month, and that Friday is the last day on which those options can trade. If the 3rd Friday is a holiday, the last trading day will be the Thursday before. Some brokerage firms institute a Friday deadline for notice of exercise by retail customers (like you and me), so be clear on whether you actually can exercise on expiration day. Be aware that options you have sold can be exercised on expiration day.

Option Term – Stock options have a life of 9 months or less – LEAPS options (discussed below) have a much longer life, nearly three years. At the end of this term, the option expires.

Open Interest – The number of contracts of an option series outstanding.

Interchangeability – Every option contract of a series is identical to every other option contract of the same series, and thus they are interchangeable (also referred to as “fungible”).

Option Trading Mechanics – You enter an option symbol (explained below) into a trade order just like a stock symbol. You don’t have to prepare an option contract, any more than you have to prepare a stock certificate for trading. All terms of stock options except strike price, expiration date and the underlying stock, are completely standardized.

Option Series – There are many different calls and puts trading on each stock that is optionable, and each different put and call strike of each expiration month is a separate option series. To be part of the same series, the options must be of the same type (put or call), and have the same expiration, strike price and the same underlying stock. Thus for example all XYZ December 2017 $35 Calls are of the same unique call series:

  • Type: Call option
  • Underlying stock: XYZ
  • Strike price: $35
  • Expiration: December 2017

If we change any of these elements, we get a different option series. EX: Change the option type to a put and we get the XYZ December 2017 $35 Put. Always be sure you are looking at the correct option series.

The Options Clearing Corporation and Option Settlement

There is no risk that, upon exercise of an option, the other side will fail to perform. The Options Clearing Corporation (OCC), the world’s largest clearing organization for options, processes all sales of put and call options and all option exercises. The OCC acts as the guarantor of every option transaction in order to ensure that there are no option defaults.

In fact, there has never been a default in buying or selling shares upon call or put exercise, for this very reason. The OCC does not guarantee anyone a profit, however; only that shares will be bought (sold) upon call (put) exercise. Note that buyers and sellers of options do not form a contract with each other; their contract is with the OCC, which is the true counterparty to the option buyer or seller.

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Stocks and Options: Similarities and Differences

Similarities

  • Options and stock both are securities. Options technically are “derivatives” since they relate to another security: shares of stock.
  • Stocks are traded on exchanges and also over-the-counter (e.g., Nasdaq, Bulletin Board, Pink Sheets). Stock options trade only on exchanges regulated by the SEC
  • Market makers buy and sell stock options, as they do stocks.

Differences

  • Stock represents an equity (ownership) interest in a company. An option is a contract.
  • Options expire on their respective expiration dates. An option not exercised by its expiration date expires worthless. Stocks never “expire” except when the company goes out of business.
  • Stocks are represented by stock certificates, although buyers often don’t see the shares because they are held in the broker’s “street name.” But options are maintained in the form of electronic book entry only, and there are no certificates that represent options.
  • At any one time, there is a fixed number of shares of stock outstanding. However, there is no limit to the number of contracts that can be created on a stock.
  • Holders of stock have the right to vote and receive dividends, but holders of stock options have neither, since the option is only a contract to buy or sell.

Moneyness: Option Strike Prices

Stock option strike prices fall into three categories, depending on their relationship to the stock’s price (known as the “money“). This relationship to the “money” is known as moneyness.

  • In the money (ITM)
  • At the money (ATM)
    This term frequently is used to refer to options near but not exactly at the money.
  • Out of the money (OTM)

Figure 2.2

CALLS Strike Price PUTS
Strike below stock price ITM Strike above stock price
Strike same as stock price ATM Strike same as stock price
Strike above stock OTM Strike below stock

The purpose of the two tables below is to illustrate the relationship of different call and put strikes to the money and how these relationships change as the stock price moves. Notice how put strikes are ITM when above the stock price, and how call strikes are ITM when below the stock price. “Intrinsic” refers to the amount the premium is in the money, if any.

At $20.78, two of the call strikes are ITM and two are OTM. Same for the puts; two are ITM and two are OTM. Figure 2.3 demonstrates their moneyness.

Figure 2.3

Moneyness – Stock Price is $20.78
Calls   Puts
Relation to Stock Price Amount ITM Strikes Amount ITM Relation to Stock Price
ITM 3.28 17.50 .00 OTM
ITM 0.78 20.00 .00 OTM
Stock Price 20.78 Stock Price
OTM .00 22.50 1.72 ITM
OTM .00 25.00 4.22 ITM

 

But notice how, in Figure 2.4, when the stock price drops to $17, all four call strikes become OTM, and all four put strikes become ITM, based solely on the movement of the stock price:

Figure 2.4

Figure 2.4               Moneyness – Stock Price drops to $17.00
Calls   Puts
Relation to Stock Price Amount ITM Strikes Amount ITM Relation to Stock Price
OTM .00 17.50 0.50 ITM
OTM .00 20.00 3.00 ITM
Stock Price 17.00 Stock Price
OTM .00 22.50 5.50 ITM
OTM .00 25.00 8.00 ITM

 

Options that are within $0.50 or so of the stock price and thus slightly ITM or OTM, frequently are referred to as near the money (or NTM) options. The term “at the money” also is used to refer to NTM options.

Figure 2.5

Note how, in Figure 2.5, the $45 Call originally is out of the money.

The call becomes at the money when the stock hits $45. It becomes an in the money call once the stock is above $45.

Understanding the moneyness of the call option is important, because then you only need remember that the moneyness of the put is the opposite, ITM and OTM.

If we change the call to a $45 Put, it also would be at the money to a $45 stock price.

But a $45 Put would be out of the money with the stock below $45, and in the money with the stock below $45 – opposite to the $45 Call option.

>> More: Why Don’t More People Write Covered Calls

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