The Basics of Calls and Puts
A logical first step to learning about options is learning the basics of calls and puts – those are the two types of stock options that exist.
Sources of information
There are many sources of information when it comes to learning about options. I chose to go straight to the Options Clearing Corporation and used The Characteristics and Risks of Standardized Options as my main source material. I also referred to OptionAlpha’sYoutube channel and various investopedia articles.
What is an option?
An option is the right to either to buy or sell a specified amount or value of a particular underlying interest (a stock) at a fixed exercise price by exercising the option before its specific expiration date.
An option holder is the person who buys the right conveyed by the option. An option writer (or seller) is obligated, if and when assigned an exercise, to perform according to the terms of the option. The obligation for the writer of a call would be to sell stock at the specified exercise price. The obligation for the writer of a put would be to purchase stock at the specified exercise price.
|Call Option||Put Option|
|Rights of option holder (buyer)||The right to buy shares of XYZ stock at the exercise price (strike price) prior to the expiration date.||The right to sell shares of XYZ stock at the exercise price (strike price) prior to the expiration date.|
|Obligations of option writer (seller)||If option holder exercises call option, assigned writer must sell the required number of shares of XYZ stock @ exercise price (regardless of market price)||If option holder exercises put option, assigned writer must buy the required number of shares of XYZ stock @ exercise price (regardless of market price)|
|In the money||Exercise price < market price (i.e. option holder can purchase stock below market price)||Exercise price > market price (i.e. option holder can sell stock above market price)|
|At the money||Exercise price = market price||Exercise price = market price|
|Out of the money||Exercise price > market price (i.e. option holder can purchase stock above market price)||Exercise price < market price (i.e. option holder can sell stock below market price)|
|Option holder believes the stock price will…||Increase||Decrease|
|Option writer believes the stock price will…||Decrease||Increase|
What roles do the OCC and Clearing Members play?
The OCC, and Clearing Members, are involved in the performance of all options. Clearing members carry the positions of all options holders and option writers in their accounts. To qualify as a Clearing Member, a firm must
- Meet OCC’ financial requirements
- Must provide OCC with collateral for positions of options writers
- Must contribute to clearing funds that protect OCC against the failure of Clearing Members
The OCC is responsible for the system that backs the performance of options. The system is made up of
- Clearing Members’ guarantees of performance of option writers’ obligations
- The financial strength of Clearing Members
- The collateral Clearing Members deposit
- The obligations of correspondent Clearing Corporations
- Clearing funds that the Clearing Members contribute to
Documentation and fulfillment
No certificates are issued to an option holder as evidence of the option. Instead, investors look to the confirmations and statements they receive from brokerage firms to confirm their positions as option holders or option writers (i.e. option buyers or option sellers). For performance of the options he or she owns, an option holder looks to the systems created by the Options Clearing Corporation (OCC) rules, rather than any particular option writer, for performance of the option. Similarly, an option writer must perform their obligations under the OCC system, and is not obligated to any particular option holder. Every options transaction involves both a holder and a writer, therefore the aggregate rights of options holders under the system is matched by the aggregate obligations of the options writers.
What happens when an option is excercised?
When an option is excercised ty an option holder, OCC will assign the exercise according with rules to a Clearing Member whose account with OCC reflects the writing of an option. Clearing Members in turn may assign exercise to one of its customers in accordance with the Clearing Members’ procedures. The “assigned writer” will then be obligated to perform the obligations of the option: an assigned writer of a call option will be obligated to sell the underlying security at the exercise price; an assigned writer of a put option will be obligated to purchase the underlying security at the exercise price.
- Covered Call Writer: If a writer of a call option owns or acquires the amount of the underlying interest (the stock) that’s deliverable upon exercise of the call, the writer is considered a covered call writer.
- Exercise: If holder of an option wishes to buy (in the case of a call) or sell (in the case of a put) the underlying interest at the exercise price, his option must be exercised. To exercise an option, an option holder must give exercise instructions to his brokerage firm.
- Exercise Price: The price at which the option holder has the right to either purchase or sell the underlying interest. The exercise price is generally set at levels above and below the market value of the underlying interest or asset (i.e. the underlying stock).
- Expiration Date: The date on which the option expires. If an option has not been exercised prior to expiration, it ceases to exist. If an option ceases to exist, an option holder no longer has any rights, and an option no longer has any value.
- Intrinsic Value: Reflects the amount, if any, by which an option is in the money.
- Long/Short: Long refers to a person’s position as a holder of an option. Short refers to a person’s position as a writer of an option.
- Opening Transaction and Closing Transaction:
- Opening Transaction: A purchase or sale transaction by which a person establishes or increases a position as either a holder or writer of an option.
- Closing Transaction: A transaction in which, at some point prior to expiration, an option holder makes an offsetting sale of an identical option, or an option writer makes an offsetting purchase of an identical option. A closing transaction reduces or cancels out an investor’s previous position as holder or writer of that option.
- Premium: The price the holder of an option pays and the writer of an option receives for the rights conveyed by an option. Premium is a nonrefundable payment in full from the option holder to the option writer for the rights conveyed by the option. Premium is subject to continuous change based on market conditions. Premium can be thought of as the time value + intrinsic value.
- Time Value: Whatever the premium of the option value is less the intrinsic value. For example, if the premium of an option is $12, and the intrinsic value is $10, then the time value is $2. Premium = intrinsic value + time value, therefore, time value = premium – intrinsic value.
- Unit of Trading, or Contract Size: The amount of the underlying interest that is subject to being purchased or sold upon the exercise of a single option contract. This is usually 100 shares.