Exactly what is an “option”? An option is a traded security that is a derivative product. By the term derivative product, we mean that it is a product whose value is based upon or derived from the price of something else. Since we are talking about stocks, a stock option is based upon, among other things, the price of the underlying stock.
Options are not only traded on stocks, they are traded on other tradable securities such as commodities, futures, currencies, indexes and interest rates, but here we will limit our discussion to stock options, or options based on stocks.
Option contracts are literally a sales agreement between two parties. The two parties are the buyer (or holder) and the seller (or writer). When you buy an option contract you are considered to “be long the option.” When you sell an option contract, you are considered to be “short the option.” This, of course, is assuming you had no previous position in the said option.
In an option contract, although it seems as though the buyer and seller must be tied together, they are not. You see, the buyer doesn’t really buy from the seller and the seller doesn’t really sell to the buyer.
In reality, an organization called the OCC or Options Clearing Corporation steps in between the two sides. The OCC buys from the seller and sells to the buyer. This makes the OCC neutral, and it allows both the buyer and the seller to trade out of a position without involving the other party.
An option’s price can be broken down to two basic parts: intrinsic and extrinsic value. Intrinsic value is the amount by which the option is in the money. In other words, it is the amount of money which the option provides as an immediate, innate value. Extrinsic Value is the amount of money of the option’s price that is over and above the intrinsic value. It is commonly referred to by option pro’s as premium. This value is associated with the future potential of the stock and is the decayable value of the option. As time goes by, the option loses its extrinsic value as it moves closer to its expiration date. But, it is important to note that the decayable value part of the option is the extrinsic value and the extrinsic value only!
When we speak of options in terms of volume, we use the term contracts. Each stock option contract is equivalent to 100 shares of stock. When we talk about two contracts, we are talking about 200 shares, 10 contracts; we are talking about 1,000 shares, 75 contracts 7500 shares and so on.
|Amount of Shares||Equivalent Amount of Option Contracts|
NOTE: It is important to understand the dollar cost of options before actually trading them. When an option is quoted at $1.75 per contract (for example), the investor must realize that the $1.75 represents a price of $1.75 per share per contract, not just per contract. Remember that each contract is worth 100 shares. This means that if you were to buy one option contract at a quoted price of $1.75, your total cost will be $175.00 (1 contract x $1.75 per share x 100 shares per contract). If you were to buy 2 contracts for $1.75, your total cost would be $350.00 (2 contracts x 1.75 per share x 100 shares per contract). If 10 contracts for $1.75 per contract, your total cost will be $1750.00. Use the formula below when calculating total dollar cost of the option.
Total Dollar Cost of Trade = Number of Contracts x Price per Contract x 100
NOTE – Please realize that this article is presenting rudimentary information on options. There is MUCH more to it. That is why we teach about them! There is more to them than you can go out and simply read about!