What Is an Option?

By Markets Fool.com

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Most investors are familiar with stocks and equities, but there are several alternative ways to invest in the price movements of securities. Options are a popular form of derivative, whose value is derived from the price of an underlying security.

Equity options are standardized and traded on exchanges, which facilitates greater liquidity and more favorable price continuity compared to other forms of derivatives that trade over the counter, such as forwards. Option contracts typically represent 100 shares of the underlying stock, but the deliverable may be adjusted based on various corporate actions such as mergers, acquisitions, or stock splits, among others.

The basics

An option is a contract that grants the owner the right to buy or sell an underlying asset. Every contract has two counterparties, a buyer/holder (long side) and a seller/writer (short side). Additionally, all options have three basic characteristics:

  • Call or put: A call is a contract that allows the call buyer to purchase the underlying stock from the call writer, while a put option is a contract that allows the put buyer to sell the underlying stock to the put writer.
  • Strike price: The pre-specified price at which the underlying stock is bought or sold.
  • Expiration date: The date at which the option expires.

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The price of the option is considered a premium, and is paid from the buyer to the seller. The value of the option will fluctuate based upon factors related to market conditions. The option owner can voluntarily exercise the option at any point up until expiration. If exercised, the option seller has an obligation to either deliver or purchase the underlying security. Since stock options derive their value from the underlying stock and have the potential to become worthless upon expiration, they generally carry more risk and are considered speculative investments.

An option is considered in-the-money (ITM) if the stock price is higher than a call strike price or lower than a put strike price.

An option is considered at-the-money (ATM) if the stock price is currently trading near the strike price.

An option is considered out-of-the-money (OTM) if the stock price is lower than a call strike price or higher than a put strike price.

Option value is comprised of two components: intrinsic value and time value. The intrinsic value is the difference between the current stock price and the strike price. Only ITM options have intrinsic value, since they can be exercised at positive value (before factoring in the initial cost of the option). The time value is based upon how much time is left until expiration.

There are a wide range of investing strategies that can be implemented using various combinations of buying and selling calls and puts at different strike prices and expiration dates.

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