Basics Of An Options Contract
July 6, 2009 by Tisa Silver
Filed under Finance
What exactly is an option? An options contract is a derivative security which gives its holder the right to buy or sell shares of an underlying security at a specified price within a specified time frame.
Today, I’ll examine some options basics: calls vs. puts, American vs. European, contract sizes and settlement.
Photo by ndevilTV, courtesy of flickr
Call – A call option gives its owner the right to buy shares of an underlying stock at a specified price (known as the strike price) within a set time frame.
A person who buys a call option believes the market price of the stock is poised to rise above the strike price. A rising stock price will allow the person to buy shares at a discount to their market value and profit from the difference.
Put – A put option gives its owner the right to sell shares of an underlying stock at the strike price within a set time frame.
This person believes that the market price of the stock is going to fall below the strike price. If so, the person will be able to sell the shares at a premium to their market value and profit from the difference.
American vs. European – This has nothing to do with geography! American options can be exercised at any point up to, and including, the expiration date. European options can be exercised at expiration only.
Contract size – Option contracts are standardized. Each contract represents 100 shares of stock.
Settlement – You may elect to have shares move (by actually buying or selling them once you exercise the option) or you can opt for cash settlement, in which case only the payoff would be transferred.
An example: Shares of Dell are currently trading at $13.42 per share. A call option on shares of Dell with a strike price of $15 and August 2009 expiration is currently trading for $0.15/share. (View the quote)
Purchasing one of these call contracts would cost you $0.15 x 100 = $150 (ignoring any commissions). If Dell’s shares rose to $20, you could exercise the option and buy them for $15.
You could then hold on to the shares, or immediately sell them at $20 to collect the $5 payoff. With cash settlement, the option writer would just pay you the $5 per share. In both cases, after accounting for the $150 premium, you would walk away with $500 – $150 =$350.
If shares of Dell fell to $10 each, you would not exercise the option since it would force you to pay $15 for a share of Dell that is only worth $10. Since it would not be profitable, you wouldn’t have to exercise the option. You will lose the $150 premium.
In a nutshell, options provide flexibility. You pay a premium up front for the freedom to buy or sell shares later and at a set price. Tomorrow, I’ll cover how to buy options.
