An options contract imparts the right to buy or sell an underlying security at a given price, known as the strike. Options trade under a four- or five-letter symbol, of which the first two or three letters refer to the underlying stock. Expiration is always the third Friday of the month, so,since calls are identified by the letters A to L (from January to December) and puts from M to X, a single letter in the penultimate position reveals whether the option is a put or a call and the exact date of expiration. The final letter relates to the strike price, which varies based on the normal trading range of the stock. Generally, all the calls expiring in a given month will be identical except for the final letter. Calls of the same strike price expiring in different months will be identical except for the penultimate letter.
The inherent value of an option is derived from the relationship between the strike price and the actual market price of an option. If a stock trades for $30, then a call option conveying the right to buy that share for $25 has a $5 intrinsic value, which will fluctuate as the share prices changes. The time value of the option is based on the distance to maturity of the option. In the example above, if there are still several weeks or months to expiration, the option will trade at a price significantly higher than the inherent $5 value, a "premium" based on the assumption that the share price can continue to move higher and create even more value before expiration. The effect of changes in the underlying stock on the value of an option is called "delta," and is given as a coefficient of the change in the share price. Thus, an option with delta of 0.5 would experience a one-point change for every two-point change in the stock price. As expiration approaches, the time value of the option erodes exponentially as the clock literally runs out on the option. The impact of a change in time remaining is known as an option's "theta" value. On the date of expiration, the remaining time value is exactly nil, so the option's total value is entirely based on the relationship between the strike price and the share price.
A call option is named as such because the owner of the option can call on the seller of the option to make shares of the stock available at the strike price. Each option contract controls rights to 100 shares of stock, which makes options a relatively inexpensive way to play the stock market and accumulate shares. One strategy is to buy calls that are already "in the money," meaning that the strike price is already below the actual market price of the stock. At expiration, the total price paid for the shares will be the strike price plus the option price, which could represent a significant value if the share price continued to rise after the options were purchased. If the options holder does not wish to spend the capital to actually buy the shares, he can sell his call option, most likely at a profit if the share price has risen in a short period of time. The relationship between the increase of the share price and the increase in a call option's premium (recall this is a ratio known as "delta") is based on the proximity of the strike price and the share price. Once the share price increases, delta will also change in a predictable manner. The rate of change in delta is called "gamma," and is used by investors to calculate how different options contracts will react to changes in the share price.
One of the most popular uses of call options, however, is not buying, but selling them. The owner of 100 shares of a stock can sell a single call option, known as a covered call, and keep the proceeds. This is done to generate income from the stock, to create a cushion against a small potential decline in the share price or to sell the stock altogether. If, at the time of expiration, the share price has fallen below the strike price, then the call expires worthless and the seller of the option keeps all of the proceeds as profit. If the strike price is below the market price, then the seller is called and sells the shares at the strike price, realizing net proceeds of the strike price plus the option sale price, which together can exceed the actual market price of the stock. Selling covered calls is the safest options strategy because at worst it either provides some insurance against price declines or merely limits the potential profit on a stock holding. The deeper in the money an option is when it is sold, the larger the immediate credit the seller will receive and the more downside protection they will have. At the same time, the lower strike price also makes it more likely the seller will be called and forced to part with his shares.
Options and Risk
Because of their time component, options are among the most risky trading vehicles. Most, in fact, expire worthless. Whereas an investor can buy a stock and hold it for the long term, collecting the dividend and eventually selling it at a profit even if it immediately sunk in value after the purchase, the owner of call options rarely has this luxury. Because time decay increases exponentially as expiration approaches, it's possible for out of the money call options to lose value even as the share price increases. Quantifying the time value of an option also involves a component of implied volatility, which tends to decline as the share price decreases. The impact of a change in the implied volatility of a stock is known as "vega." Because of the various risks involved with options, most are used to hedge a stock position or other options. In fact, most options strategies involve combinations of buying and selling to produce a configuration that ultimately has a much more manageable risk profile.