Options are contracts on stocks, indexes, currencies, commodities, or debt instruments. There are two principle types. These are call options and put options. Call options give holders the ability to purchase a set amount of the underlying instrument for a specific price in a certain amount of time. This specific price is known as the strike price. Put options grant holders the ability to sell the exact amount of the underlying instrument at a fixed price in a given period of time.
With options on stocks, the set amount of the underlying shares that calls and puts cover are typically 100 shares. Option contracts have two parties to them. The first are the sellers who are also known as writers of the option. The buyers are the holders of the option.
Option values are made up of two components. These are intrinsic value and time value. Intrinsic value is the amount that the option is in the money. For an option to be in the money, the stock price must be higher than the strike price for calls. For puts, the stock price has to be lower than the strike price. The value that is left after subtracting intrinsic value is the option’s time value. When an option has no intrinsic value, one hundred percent of its value is time value.
Investors can buy and sell options until they run out of time. At this point, they expire either with some intrinsic value or worthless. They can also be exercised. When an option is exercised, the seller must transfer the underlying shares to the holder of the option. When the instrument is not able to be transferred over, then the parties settle in cash instead.
Investors like this financial tool because they give buyers peace of mind. The most an option holder is able to lose is the total price that they paid when they bought the contract. If options are not exercised or sold within the given time frame, then they expire. An option that expires worthless does not involve any exchange of shares or cash.
Buyers and sellers have different potential profits with options. Profit potential is limitless for the buyers. For the sellers, the profit is limited to the price which they receive for the contract. Sellers have unlimited loss potential unless they own the underlying shares or instrument. When a seller of an option holds the underlying instrument, the option is covered.
There are two main reasons that investors buy options. These can be to gain leverage or to obtain protection. The leverage benefit means that the option holder can control a larger amount of equity for a much smaller price than it costs to actually buy the shares. This exposes the buyer to a far smaller potential loss.
Options provide protection to investors who own the shares that underlie the contract. While the owners of the option hold the contract, they gain protection against adverse price movements in their shares. This is because the contract provides the ability to obtain the stock at a certain price during the option’s contract time-frame. In this case, the cost of the option is the premium that the owner pays.
There are several downsides to options. The trading costs for options are higher than with buying the underlying shares of the stock or other instrument. This is because the spread between the bid and ask is higher for options. Option commissions also cost more than do stock commissions.
Option trading is more complicated than stock trading too. Options also have to be watched more closely than do stocks generally. The time involved to trade and maintain option strategies can be significant.