An option is the right, but not the obligation, to the underlying instrument at a particular price and particular time. The underlying instrument can be a stock, futures contract, index security, interest rate, or other market-traded instrument.
There are two types of options traded on the market, call options and put options:
• A call option is the right, but not the obligation, to buy the underlying instrument at a particular price and particular point in time.
• A put option is the right to sell, or be short, the underlying instrument at a particular price and particular point in time.
Let’s look further at our definition of an option:
• An option is the right, but not the obligation—an option gives the option buyer the right to buy or sell (call or put) the underlying instrument.
• At a particular price—this price is determined by the option purchased and is referred to as the strike price.
As an example, if ABC Company is trading at around $15.00 anthere is an option strike price at $16.00, then the $16.00 call option would give the call buyer the right, but not the obligation, to be long or buy ABC Company’s stock at $16.00. A buyer of the $16.00 put option would have the right, but not the obligation, to sell or be short ABC Company’s stock at $16.00.
• At a particular point in time—options are limited term instruments, meaning they have a set date at which they will expire. This term can be as short as a few days or a year or more into the future.
Each option is represented by the month of expiration, the strike price, and the type of option, for example the ABC Company, August, $16.00 call option.
Options have a cost commonly referred to as the option’s premium. Just like a car insurance policy has a premium for you to buy a certain amount of coverage for your car, an option has a similar theory. You are paying a premium for the right, but not the obligation, to the market. This premium is determined by supply and demand in the market. Like other securities, options are bid, offered, and traded actively on the market.
Option writers are investors who are willing to take the risk for a price or premium that the option will
have no value at expiration or that the premium will be reduced and that they can purchase back the option at a lower price.An option seller or writer is taking the risk and demanding premium for that risk. As
in most every investment, the more assumed risk the investor takes on, the more reward the risk taker wants in return.
ATM, ITM, and OTM
• At the money (ATM): This means that the strike price of the option is in very close proximity to the current underlying instrument pricing. If ABC Company is trading at 15.00, then the 15.00 call would be considered at the money.
• In the money (ITM): This refers to options for which the underlying instrument price has surpassed the option’s strike price in the direction of the option. If ABC company is trading at 15.00, then the 14.00 call option would be considered in the money.
• Out of the money (OTM): This refers to options for which the underlying instrument price has not yet reached the strike price of the option. Again this would be in the direction of the option, call versus put. If ABC Company is trading at 15.00, then the 14.00 put option would be out of the money.
Intrinsic and Extrinsic Value
Intrinsic value is present in options that are in the money. This value is related to the option’s strike price and the current price of the underlying instrument. A call option has intrinsic value when the underlying price is higher than the strike price of the option. A put option has intrinsic value when the underlying price is lower than the strike price of the option.
Here is how intrinsic value on a call option is calculated:
Underlying price – strike price = intrinsic value
This is how intrinsic value on a put option is calculated:
Strike price – underlying price = intrinsic value
Extrinsic value can be described as the risk value of the option. When you purchase an option, you are compensating the writer for the risk and time of selling the option. Included in the time value of the option is the risk assumed from the volatility of the market. If the market price fluctuates wildly, the writer naturally assumes that there is more risk than if a price is very stable, so the time value of the option would be further increased on the more volatile options. The longer the time remaining until the option expires, the more the perceived risk of the option and therefore the higher the premium. More time, more risk, more premium.