Chapter 7: Options
A stock option gives an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise.
One equity options contract generally represents 100 shares of the underlying stock.
There are two primary types of options contracts: calls and puts.
The volatility of the underlying security is a key concept in options pricing theory. In general, the greater the volatility, the higher the premium required for all options listed on that security.
Options are a type of financial instrument known as a derivative. This means their worth is based on, or derived from, the value of an underlying security or asset. In the case of stock options, that asset is shares of a company's stock. The option is a contract that creates an agreement between two parties to have the option to sell or buy the stock at some point in the future at a specified price. The price is known as the strike price or exercise price.
Stock options come in two basic forms:
Call options afford the holder the right, but not the obligation, to buy the asset at a stated price within a specific timeframe.
Put options afford the holder the right, but not the obligation, to sell the asset at a stated price within a specific timeframe.
Therefore, if XYZ stock is trading at $100, a $120-strike call would become worthwhile to exercise (i.e., convert into shares at the strike price) only if the market price rises above $120. Or, an $80-strike put would be worthwhile if the shares drop below $80. At that point, both options would be said to be in-the-money (ITM), meaning that they have some intrinsic value (the difference between the strike price and the market price). Otherwise, the options are out-of-the-money (OTM), and consist of extrinsic value (also known as time value). OTM options still have value since the underlying asset has some probability of moving into the money on or before the option expires. This probability is reflected in the option's price.
Equity options are derived from a single equity security. Investors and traders can use equity options to take a long or short position in a stock without actually buying or shorting the stock. This is advantageous because taking a position with options allows the investor/trader more leverage in that the amount of capital needed is much less than a similar outright long or short position on margin. Investors and traders can, therefore, profit more from a price movement in the underlying stock.