Acquire the basic language of stock options, as well as a broad understanding of the roles and responsibilities of buyers and sellers of option contracts; and earn about the role of an option contract owner or writer (of a call or put)
Now that we’ve covered some of the basic ideas that broadly define stock options, we’ll now address some specific terms and meanings, as well as examine the roles and obligations of buyers and sellers of options contracts.
A stock option is basically a contract, whereby a buyer and seller agree to a specified number of shares of a particular stock, at a fixed price, and over a defined period of time.
There are two main types of option contracts:
A call contract gives the holder of the contract the right, but not the obligation, to buy stock at a pre-determined price over a given period of time.
A put option offers its holder the right, but not the obligation, to sell stock at a pre-determined price over a given period of time.
As you can see, stock options have buyers and sellers – not unlike any other financial transaction – each with their own responsibilities for their side of the contract.
If you purchase an options contract, you are then considered the holder or owner of that contract and “long” in an option position. As the contract owner, you have the right, but not the obligation, to buy or sell the underlying stock, depending on the type of option that you’ve bought – whether a call or a put.
As a buyer, you’ll pay what is called ‘a premium’ to the seller. This payment is the same as the market price for the contract and can fluctuate with certain changes in market dynamics.
As the contract owner, you have the choice to exercise your option under the terms of your agreement – that is you can take delivery, or deliver, that set number of underlying shares at, or before, the time the contract expires, or you can let the contract expire at its expiration date without exercising that right.
The option holder also has the right to sell the option to another buyer during the lifetime of the contract or allow it to expire worthless.
On the other side of the contract is the seller, who may be referred to as the contract writer, and “short” the option position.
As the contract writer, you are obligated to fulfill the terms of your contract with its holder, should the buyer decide to exercise their right. The premium you receive from the buyer is essentially in exchange for this obligation.
What happens if a buyer exercises their right?
Depending on the type of contract sold, you, as an options contract writer, would be required to either buy or sell the underlying shares at the pre determined price that was agreed upon.
An options contract has two sides – a buyer and a seller.
In the case of a call, the owner has a right to purchase stock at a pre-determined, fixed price, and if that right is exercised at or before expiry, the seller is required to sell that stock to the buyer at that price – regardless of what that stock’s price is in the market at that time. For a put option, the buyer has a right to sell stock at a pre-determined, fixed price, and if that right is exercised, the writer is obligated to buy it under the same conditions.
If you’re a buyer of an options contract, you’re going to pay a premium to the writer, and if the option expires worthless, that payment will end up being your maximum loss. If you’re the seller receiving this premium, and that option expires worthless, this payment will be the most you’ll gain from the transaction.
However, since options don’t always expire worthless, there are several strategies a trader may use to generate income, or mitigate risk, or face other potential positive or adverse outcomes, and these will be discussed further along in this course.
We’ll also discuss how to calculate your breakeven point, that is – determining at what price the underlying security in your options contract needs to be trading at, so that you don’t lose – or make any gain – from your investment.
In the meantime, we’ll next show you how you can identify options on a trading platform, and we’ll also further define their key components and characteristics.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Supporting documentation for any claims and statistical information will be provided upon request.
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.
Disclosure: Options Trading
Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or click here. Multiple leg strategies, including spreads, will incur multiple commission charges.