Investing in Options
While many investors may believe that options are a product of recent financial innovation, options were, in fact, conceived thousands of years ago. Some market historians trace the origins of options as far back as ancient Greece and the philosopher Thales.
In the United States, stock options began trading in the late eighteenth century and grew into a large over-the-counter business by the middle of the twentieth century. The standardized equity options that dominate today’s market began trading on the Chicago Board Options Exchange (CBOE) on April 26, 1973.
Today, thousands of standardized options contracts on individual stocks, stock indexes, government bonds, currencies, precious metals, and futures contracts trade at some 57 exchanges in 27 countries throughout the world.
Options belong to a broad category of securities known as derivatives or contingent claims. A derivative is a contract or agreement whose value is derived from or contingent upon the value of a related asset that is referred to as the underlying asset. In exchange for the payment called the option premium, which is the price of the option in the marketplace, an option contract gives the option owner the right, but not the obligation, to buy or sell the underlying asset (or to settle the value for cash) at a specified price any time during the designated period or on a specified date. It is important to note that the owner of an option can also choose not to exercise the option and to let it expire worthless. So by exercising, the owner benefits from a favorable move in the price of the underlying asset, and by not exercising, the owner does not suffer the loss that results from an unfavorable move. In contrast, the seller or writer of an option is always obligated to fulfill the terms of the contract if the owner exercises it.
There are six specifications or terms that uniquely and completely define an option contract: option type, underlying asset, strike price, expiration date, exercise style and contract unit. They will be defined below.
There are two types of simple options, calls and puts. A call option gives the holder the right, but not the obligation, to buy the underlying asset at a predetermined price on or by a certain date. A put option gives the holder the right, but not the obligation, to sell the underlying asset at a predetermined price on or by a certain date.
Options are available on a large and diverse group of underlying assets including individual stocks, stock indexes, government bonds, currencies, precious metals, and futures contracts.
The strike price, also called the exercise price is the price at which the option owner can buy or sell the underlying asset.
The expiration date is the date on which the option and the right to exercise it cease to exist.
There are two primary exercise styles, American and European. American options can be exercised at any time before the expiration date, while European options can be exercised only on the expiration date.
The contract unit is the amount of the underlying asset that the option owner can buy or sell for the strike price upon exercise. In the United States, the contract unit for individual stock options is usually 100 shares of stock, and for stock index options it is an amount of money equal to $100 times the index value. Therefore, a call option quoted at a price of $5 and struck at $50 entitles the owner to buy 100 shares of the underlying stock for $5000 at a later date. The price that the owner pays for this right is $500 (not including commissions).