Options Trading Basics

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 book 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)
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 in this book.

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 Microsoft December 2007 $35 Calls are of the same unique call series:

  • Type: Call option
  • Underlying stock: Microsoft
  • Strike price: $35
  • Expiration: December 2007

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 Microsoft December 2007 $35 Put. Always be sure you are looking at the correct option series.

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