Unit
- Definition: A stock option is a contract that grants the holder the right, but not the obligation, to buy or sell a specific number of shares of an underlying stock at a predetermined price on or before a specified expiration date. Options are derivative instruments because their value derives from the underlying stock.
- Call option: A call gives the holder the right to buy the underlying stock at the strike price. Buyers of calls expect the stock price to rise, while sellers (writers) collect a premium and assume the obligation to deliver shares if exercised.
- Put option: A put gives the holder the right to sell the underlying stock at the strike price. Put buyers anticipate a decline in the stock price, while put writers receive a premium and must buy the stock if assigned.
- Moneyness: In-the-money (ITM) options have intrinsic value; at-the-money (ATM) options have a strike price near the current stock price; out-of-the-money (OTM) options have no intrinsic value. Moneyness influences premium and exercise likelihood.
- Premium: The market price of an option, paid by the buyer to the seller. Premiums are quoted per share, but one contract typically covers 100 shares, so the cost is the quoted premium multiplied by 100.
- Exercise and assignment: Option holders can exercise their right before expiration (American style) or only at expiration (European style). When exercised, the option writer is assigned and must fulfill the contract terms.
- Underlying asset: Options can be written on stocks, ETFs, indexes, futures, and currencies. Stock options are the most common for retail investors and are traded on exchanges like the Chicago Board Options Exchange (CBOE).
- Contract standardization: Listed options have standardized terms: strike price intervals, expiration cycles, and contract size (usually 100 shares). Standardization enables liquidity and transparent pricing.
- Intrinsic and time value: An option's premium consists of intrinsic value (the amount by which it is in the money) and time value (the remaining time until expiration). As expiration approaches, time value decays, accelerating in the final weeks. Understanding this split helps assess whether an option is overpriced or underpriced.
- Basic strategies: A covered call involves owning the stock and selling a call to generate income, capping upside. A protective put involves buying a put on owned stock to hedge downside risk. These are foundational strategies that limit risk while providing exposure.
- Expiration and time decay: Options are wasting assets; their time value erodes as expiration nears, a phenomenon known as theta decay. Short-term options experience faster time decay than long-term options. Traders must account for this when choosing expiration dates, as it directly impacts profitability.
Risk Assessment
HIGH RISK
Option trading involves substantial risk due to leverage and time decay. Buyers can lose the entire premium paid, while sellers face potentially unlimited losses on uncovered calls. Beginners should start with limited-risk strategies and understand the risks of each position before entering.
Quick Revision
- A stock option is a contract giving the right to buy (call) or sell (put) shares at a fixed price by a certain date.
- Moneyness (ITM, ATM, OTM) affects an option's intrinsic value and premium.
- Premiums are quoted per share; each contract represents 100 shares.
- Option exercise and assignment depend on style (American vs. European).