Chapter 6 : Options

Option

A derivative contract that gives one party the right, but not the obligation, to buy or sell an underlying asset at a fixed price within a specified time period. The value of an option is derived from the price of another asset, called the underlying asset.

Derivative

A financial instrument whose value is based on, or derived from, the value of another asset, such as a stock, index, interest rate, or currency.

Underlying Asset

The security or asset on which an option contract is based. For equity options, the underlying asset is common stock.

Call Option

An options contract that gives the buyer the right to buy the underlying stock at a specified strike price before or at expiration, and obligates the seller to sell the stock if the option is exercised.

Put Option

An options contract that gives the buyer the right to sell the underlying stock at a specified strike price before or at expiration, and obligates the seller to buy the stock if the option is exercised.

Option Buyer (Holder / Owner / Long)

The party that purchases an option. Buyers have rights but no obligations. They may choose whether or not to exercise the contract.

Option Seller (Writer / Short)

The party that sells an option. Sellers receive the premium and take on an obligation to perform if the option is exercised.

Premium

The price of an option contract, paid by the buyer to the seller. Quoted on a per-share basis and multiplied by 100 shares per contract. The premium is the maximum loss for buyers and the maximum gain for sellers.

Contract Size

The number of shares controlled by one options contract. For equity options, one contract represents 100 shares of the underlying stock.

Strike Price (Exercise Price)

The fixed price at which the option buyer can buy (calls) or sell (puts) the underlying stock.

Expiration Date

The date on which an option contract terminates. Listed options expire on the third Friday of the expiration month.

American-Style Option

An option that may be exercised by the buyer at any time before expiration. Most equity options are American-style.

European-Style Option

An option that may be exercised only on the expiration date. Many index options are European-style.

LEAPS (Long-Term Equity Anticipation Securities)

Long-term options contracts with expiration dates up to three years from issuance.

Class

All options of the same type (calls or puts) on the same underlying security.

Series

All options within a class that have the same strike price and the same expiration date.

In-the-Money (ITM)

A condition in which an option has intrinsic value.
• Call: market price is above the strike price
• Put: market price is below the strike price

At-the-Money (ATM)

A condition in which the market price of the underlying stock equals the strike price.

Out-of-the-Money (OTM)

A condition in which an option has no intrinsic value.
• Call: market price is below the strike price
• Put: market price is above the strike price
OTM options expire worthless at expiration.

Exercise

The act of using the right granted by an option contract to buy or sell the underlying stock at the strike price.

Assignment

The process by which the OCC randomly selects a short position to fulfill the obligation when an option is exercised.

Intrinsic Value

The amount by which an option is in-the-money.
• Call: market price − strike price
• Put: strike price − market price
Intrinsic value cannot be negative.

Time Value

The portion of an option’s premium that reflects the time remaining until expiration. Time value declines as expiration approaches.

Opening Transaction

A trade that establishes a new options position, either by buying or selling an option.

Closing Transaction

A trade that eliminates an existing options position. Must be the opposite of the opening transaction using the same series.

Closing Sale

Used to close a long position by selling the option.

Closing Purchase

Used to close a short position by buying back the option.

Long Call

Buying a call option. A bullish strategy that profits when the underlying stock price rises.

Long Put Breakeven

Strike price − premium paid.

Short Put

Selling (writing) a put option. A bullish or neutral strategy that profits when the stock stays flat or rises.

Covered Put

A put option written with enough cash set aside to purchase the stock if assigned.

Uncovered Put

A put option written without depositing the full cash required to buy the stock. Risk is substantial but limited (unlike uncovered calls).

Protective Call

A strategy combining a short stock position with a long call to limit upside risk on the short sale.

Protective Put

A strategy combining long stock with a long put to protect against downside risk while retaining upside potential.

Hedge

An investment position taken to reduce or offset the risk of another position.

Index Option

An option whose underlying asset is a stock index rather than a single security.

Cash Settlement

Settlement method for index options where no stock changes hands; the difference between the index value and strike price is paid in cash.

VIX (Volatility Index)

An index that measures expected volatility of S&P 500 options. VIX options are European-style.

Listed Options

Options traded on a registered national securities exchange and issued by the OCC.

Options Clearing Corporation (OCC)

The clearing agency that issues listed options, guarantees contract performance, and acts as the counterparty to every options trade.

Assignment Process

The OCC’s method of selecting which short position must fulfill an exercised option obligation.

Settlement (Options)

Completion of an options trade. Listed options settle T+1 (one business day after trade date).

Automatic Exercise

The OCC automatically exercises any expiring equity option that is $0.01 or more in-the-money unless the customer instructs otherwise.

Dividend Consideration with Options

Option holders do not receive dividends unless they exercise and become stockholders of record before the record date.

Stock Dividend Adjustment

When a stock dividend occurs, options contracts are adjusted by increasing the number of shares per contract and reducing the strike price proportionally, while total contract value remains unchanged.