Frequently Asked Questions
Options are broadly classified into ‘Call’ and ‘Put’
Call: Is a contract that allows the option buyer (after paying an option premium) to have the right but not the obligation to buy the underlying asset (typically 100 shares) at the strike price within a specified time. The seller of the option (after receiving an option premium) is obligated to sell the underlying asset to the buyer at the exercise price if the buyer exercises his right.
Put: Is a contract that allows the option buyer (after paying an option premium) to have the right but not the obligation to sell the underlying asset (typically 100 shares) at the strike price within a specified time. The seller of the option (after receiving an option premium) is obligated to buy the underlying asset from the buyer at the exercise price if the buyer exercises his right.
AAPL US 03/19/21 P120
- AAPL US: the symbol of the underlying asset (Ordinary APPLE shares)
- 03: month of expiration
- 19: day of expiration
- 21: year of expiration
- P: Put (Call if is C)
- 120: strike price of the contract
ITM: In-the-money options are those options that have intrinsic value if exercise
- Calls with strikes below where the underlying is currently trading
- eg. Call strike: 100, Current underlying price: 120 (Call < Underlying)
- Puts with strikes above where the underlying is currently trading
- eg. Put strike: 100, Current underlying price: 80 (Put > Underlying)
ATM: At-the-money options are those options that have a strike price closest to where the underlying asset is currently trading at
- Call/Put with strikes roughly the same where the underlying asset is currently trading at
OTM: Out-of-money options are those options that have no intrinsic value if exercise
- Calls with strikes above where the underlying is currently trading at
- eg. Call strike: 120, Current underlying price: 100 (Call > Underlying)
- Puts with strikes below where the underlying is currently trading at
- eg. Put strike: 80, Current underlying price: 100 (Put < Underlying)
Delta: measure the change in the price of an option with a $1 change in the price of the stock. Delta for call range between 0 to 1 while for put range between 0 to -1.
- E.g. Delta of 0.5 means if the underlying stock increase in price by $1, the option price will rise by $0.5.
Gamma: reflects the rate of change in the delta in response to a $1 change of the underlying stock price.
- E.g. Gamma of 0.1 means if the underlying stock price increasse by $1, the option delta will increase by a corresponding 10%.
Vega: measure the price sensitivity of an option to changes in the volatility of the underlying stock.
- E.g. Vega of 0.2 means if the implied volatility of the option increase by 1%, the option price will increase by a corresponding $0.2.
Theta: also known as time value of option measure the rate of decline in the value of an option due to the passage of time.
- E.g. Theta of 0.9 means the option price will decrease by $0.9 per day till expiration.
Rho: measure the rate at which the price of an option changes relative to a change in the risk-free rate of interest i.e. U.S Treasury bill’s risk-free rate.
- E.g. Rho of 0.2 means the option price will increase by 0.2 for 1% increase in the risk-free rate.
Greeks are dynamic and will change throughout up till expiration of the option.
Exiting of an option position
There are two ways to close out an open option
- Let the option lapse (for options that are not ITM of $0.01 or more which are subjected to auto-exercise by the OCC)
- Enter into an opposing option to net off the position
- Eg. Short a call with the same underlying asset and expiration date to exit an open position in a long cal
- Eg. Long a put with the same underlying asset and expiration date to exit an open position in a short put
Options Clearing Corporation (OCC) randomly assigns the exercise notices it received to the open interests of its clearing members as part of their processing sequence. The clearing member will then randomly assign these exercise notices(via an automated assignment algorithm) to those short positions of the particular notice. Seller of options have no control over the assignment and will have to fulfil the obligation as per the option contract.
Positions expiring in the current month that are ITM as per below threshold will be subjected to auto-exercise by the OCC without the need for any explicit instructions. Auto-exercise happen only on option expiration only. Intention to avoid the auto-exercise by the OCC for the options held must have the position closed off prior to expiry.
- Stock options that are $0.01 or more ITM
Stock price may experience huge price movement during extended hours trading which may warrant the option auto-exercised to be OTM in normal circumstances.
Any change for the option caused by corporate action will be handled by the OCC and will be publish on their website for the change of the option based on the corporate action. All affected options will be automatically adjusted based on the notification from OCC.
The risks from buying options (if you decide not to sell them before expiration) are that they will expire worthless, assuming they are out-of-the-money. On expiry, if the option is ITM by 0.01 or more it will be auto-exercise by the OCC. Post auto-exercise, the underlying stock price may have drastic price movement during extended hours trading which in normal circumstances warrant the position to be OTM. As such, positions delivered/taken delivery may experience a loss instead even though auto-exercise is ITM.
Aside from buying options, many investors get excited about selling options because they get paid upfront for their trades.
Investors that sell short puts and covered calls are taking on specific risks. In the case of a cash secured put write, you risk being put stock, which we mentioned above. Let’s look at the Microsoft (MSFT) December 21st $110 Put Write, which expired in-the-money, again.
If we sold one contract, we would be required to purchase 100 shares for $110 per share at expiration, costing $11,000. Every put write carries the risk of exercise. However, this is unlikely to happen, hence selling too many options that expire in the money can be costly.
In the case of a covered call strategy, the risk is the buyer will call your stock away.
Assuming you bought 100 shares of Microsoft for $110 per share, your invested capital is $11,000. You decided to engage in a covered call strategy. If your covered call expires in-the-money, you would have been required to sell your 100 shares for $100. The buyer would have paid $10,000, resulting in loss in money on our trade. But of course, you still keep the premium from the selling of the call option.
When selling covered calls, you risk losing money from your stock position at times.
Ask — The price at which a seller is offering to sell an option or stock.
At the Money — an option is at the money if the strike price of the option is equivalent to the market price of the underlying security.
Bid — The price at which a market maker is willing to buy a security (buy it from you). Whenever a quote is obtained, the bid is always the smaller number (on the left-hand side).
Call Option — In the financial world, a call option gives the option buyer the right, but not the obligation, to buy something (or to “call” it away from the owner) at a specified price over a specified period of time.
Chicago Board Options Exchange (CBOE) — The Chicago Board Options Exchange; the first national exchange to trade listed stock options.
Combination Trades — When you take a position in both the call and put options at the same time for the same underlying security.
Covered Call (also see Buy Write) — Having a long position in an asset (stock), combined with a short position in a call option on the same underlying asset. The covered call option strategy is one of the most widely used by investors.
Exercise — When you “exercise” a call options, you “trade in” your options for the actual stock (at the agreed-upon strike price). When you exercise a put option, you force the sale of stock you own at the predetermined strike price.
Expiration Date — The day on which an option contract becomes void. The expiration date for listed stock options is the Saturday after the third Friday of the expiration month, so for most trading purposes it is the third Friday of each month.
Exercise Price — Sometimes called the “strike price” is the price at which the option holder has the right either to purchase or to sell the underlying stock.
Implied Volatility — is the volatility that is expected to happen in the future to an option. It is a mathematical formula based on an option pricing model.
In the Money (ITM) — For a call option, when the option’s strike price is below the market price of the underlying stock. For a put option, when the strike price is above the market price of the underlying stock.
Long (or Long Position) — The buying of a security such as a stock or option with the expectation that the asset will rise in value.
Market Maker — A company or person who is ready to buy or sell securities at all times.
Option — A security sold by one party to another that offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security at an agreed-upon price during a certain period of time on or before a specific date.
Open Interest — Is the number of outstanding option contracts in the exchange market.
Option Chain — A way of quoting option prices through a list of all the options (calls and puts) for a given security.
Options Class — This is the underlying security the option is written on. In OMC Oct 45 Calls, Omnicom Group is the option class, or in MSFT July 30 Calls, the option class would be Microsoft.
Options Clearing Corporation (OCC) — The issuer of all listed option contracts that are trading on the national option exchanges.
Options Contract — Denotes the deliverable quantity of goods; options are traded in contract units. Each option contract represents 100 shares of the underlying stock. Hence, it’s necessary to multiply any option premium quote by 100 to get the true cost to the option buyer (or seller).
An option quoted for $2.50 really costs $250 for each contract.
Option Holder — The person who buys the right conveyed by the option.
Options Series — Is the expiration month and strike price of an option. In OMC Oct 45 Calls, the options series would be October and 45, or in MSFT July 30 Calls, the options series would be July and 30.
Option Writer — The person who is the seller.
Out of the Money — For a call, when an option’s strike price is higher than the market price of the underlying stock. For a put, when the strike price is below the market price of the underlying stock.
Premium — The total cost of an option. The premium of an option is basically the sum of the option’s intrinsic and extrinsic (time) value. It’s the price that the holder of an option pays and the writer of an option receives.
Put Option — A put option, in the financial world, gives the option buyer the right, but not the obligation, to SELL a stock (or “put” it to someone else) at a specified price, over a specified period of time.
Strike Price — The stated price per share for which an underlying stock may be purchased (for a call) or sold for a (put) by the option holder upon exercise of the option contract.
Style of Option — The style of an option refers to when that option is exercisable. American-style options can be exercised at any time prior to its expiration while European-style options are exercised only at expiration. All equity options traded in the U.S. are American style.
Time (Extrinsic Value) — The difference between an option’s price and the intrinsic value. Also known as “time” value. Extrinsic value is made up of several important variables: the number of days left until expiration, volatility, prevailing interest rates and dividends.
Time Decay — The amount of change in the option price, which will decrease over time as the option gets closer to expiration. Since options are a wasting asset, they lose value over time. This loss increases the closer it gets to expiration.
Trailing Stop — A stop-loss order that is set at a percentage level below (for a long position) the market price. The price is adjusted as the price fluctuates (it is not adjusted downward).
Unit of Trading — For most options on equity securities, it is 100 shares.
Volatility — A measure of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualised standard deviation of returns.
Volume — The number of shares or contract that is traded in any given period of time within a security or an entire market.
Wasting Asset — An asset that declines in value over time. An option is an example because it is only valuable until expiration; after that, it becomes worthless.