Options are derivative securities, which give the holder the right, but not the obligation, to buy or sell another instrument at a fixed price before or at a fixed expiration date.

There are two types of options:

<strong>Call Options</strong>

A call option gives its owner the right to buy; it is not a promise to buy. For example, a store holding an item for you for a fee is a call option.

<strong>Put Options</strong>

A put option gives its owner the right to sell; it is not a promise to sell. For example, a lifetime money back guarantee policy on items sold by a company is an embedded put option.

Each option contract has a limited life and can be exercised within that life. Based on the expiration, options can be categorized as American or European. An <strong>American option</strong> gives its owner the right to exercise the option anytime prior to option expiration. A <strong>European option</strong> may only be exercised at expiration. There are also <strong>Bermudan options</strong> where the holder can exercise every n months up until the expiration date.

Options can be created with a variety of underlying assets. Options giving the right to buy or sell shares of stock (stock options) are the best-known options. Generally, an option contract is for 100 shares of stock. There are also index options, where the underlying asset is some market measure like the S&amp;P 500 index. Index options are cash-settled. Apart from that there are other options such as commodity options, FX options, and options on other derivatives, among others.
<h3>Characteristics of an Option Contract</h3>
An option contract has the following characteristics:

<strong>Expiration dates:</strong> The Saturday following the third Friday of certain designated months for most options.

<strong>Striking price:</strong> The predetermined transaction price, in multiples of $2.50 or $5, depending on current stock price.

<strong>Underlying security:</strong> The security the option gives you the right to buy or sell

Both puts and calls are based on 100 shares of the underlying security.

<strong>Option premium: </strong>The option premium is the amount you pay for the option.

What are Options?

While looking at an option contract, you need to look for the following four aspects:
<ol>
	<li>Whether      it is a Call or a Put.</li>
	<li>What      the underlying security is.  Options      can be written on almost anything: stock prices, stock indexes, FX rates,      interest rates, commodities, etc.</li>
	<li>The      expiration date (When does the option expire - tomorrow? Next month? Next      year?)</li>
	<li>The      fixed price (called the strike price or exercise price) you can buy or      sell at.</li>
</ol>
The following is an example of how to identify an option.

<img class="aligncenter size-full wp-image-1174" title="option_identify" src="https://financetrain.com/wp-content/uploads/2010/10/option_identify.png" alt="" width="504" height="214" />

Identifying an Option

Puts and Calls on individual stocks and on stock indices are actively traded on CBOE and many other exchanges around the world.

Before 1973, there was no trading of standardized options in the U.S. There was some trading of options on OTC market, with large transaction costs and low trading volume. Options trading dates back to the 17th century Holland, where farmers purchased put options on tulip bulbs to reduce price uncertainty

With an over-the-counter option, institutions enter into “private” option arrangements with brokerage firms or other dealers. The striking price, life of the option, and premium are negotiated between the parties involved. Over-the-counter options are subject to counterparty risk and are generally not fungible.

Exchange-traded options are fungible. For a given company, all options of the same type with the same expiration and striking price are identical

In April 1973, standardized options began trading on the Chicago Board Option Exchange. These had the following characteristics:
<ul>
	<li>Completely      standardized option contracts</li>
	<li>Few (3      or 4) maturities</li>
	<li>No      paper certificates (electronic book entries)</li>
	<li>Higher      trading volumes and liquidity, lower transaction costs</li>
	<li>All      contracts are with the Option Clearing Corporation. No risk of default      (from perspective of buyers)</li>
</ul>
Some of the major options exchanges in the U.S. are:
<ul>
	<li>Chicago      Board Options Exchange (CBOE)</li>
	<li>American      Stock Exchange (AMEX)</li>
	<li>Philadelphia      Stock Exchange (Philly)</li>
	<li>Pacific      Stock Exchange (PSE)</li>
	<li>International      Securities Exchange (ISE)</li>
	<li>Foreign      options exchanges also exist</li>
</ul>
<h3>Opening and Closing Transactions in an Option Contract</h3>
The first trade someone makes in a particular option is an opening transaction for that person.

When the individual subsequently closes that position out with a second trade, this latter trade is a closing transaction.

When someone buys an option as an opening transaction, the owner of an option will ultimately do one of three things with it:
<ul>
	<li>Sell it to someone else</li>
</ul>
<ul>
	<li>Let it expire</li>
</ul>
<ul>
	<li>Exercise it</li>
</ul>
For example, buying a ticket to an athletic event

When someone sells an option as an opening transaction, this is called writing the option

No matter what the owner of an option does, the writer of the option keeps the option premium that he or she received when it was sold
<h3><strong>The Role of the Options Clearing Corporation (OCC)</strong></h3>
The Options Clearing Corporation (OCC) contributes substantially to the smooth operation of the options market.

It positions itself between every buyer and seller and acts as a guarantor of all option trades.

It sets minimum capital requirements and provides for the efficient transfer of funds among members as gains or losses occur.

How and Where are Options Traded

Option prices can be decomposed into the option’s intrinsic value and time value.
<h3><strong>Intrinsic Value</strong></h3>
Intrinsic value is the amount that an option is immediately worth given the relation between the option striking price and the current stock price

Intrinsic value is the payoff value of the option were it possible to exercise immediately; if out of the money, zero, otherwise the difference between the strike and current stock price.

<strong>Example:</strong>

Let us look at the option prices of Union Pacific Corp. The closing price of UNP was 86.31.
<p style="text-align: center;"><img class="aligncenter size-full wp-image-1180" title="option_quotes" src="https://financetrain.com/wp-content/uploads/2010/10/option_quotes.gif" alt="" width="563" height="401" /></p>
The November 2010, $40 strike call is selling for $47.950. The closing UNP price was $86.31.47.  So $86.31-$40.00=$46.31 is the intrinsic value of the option.

For a call option, intrinsic value = Stock price – Striking price

For a put option, intrinsic value = Striking price – Stock price

<strong>Points to remember:</strong>

Intrinsic value cannot be less than zero

An option with no intrinsic value is out-of-the-money

An option whose striking price is exactly equal to the price of the underlying security is at-the-money.

Options that are “almost” at-the-money are near-the-money

<h3><strong>Time Value</strong></h3>
<span style="font-weight: normal; font-size: 13px;">Time value is equal to the premium minus the intrinsic value</span>
As an option moves closer to expiration, its time value decreases (time value decay)

An option is a wasting asset.

<strong>Example:</strong> The November 2010, $40 strike call is selling for $47.950. The closing UNP price was $86.31.47.  So $86.31-$40.00=$46.31 is the intrinsic value of the option. The remaining $1.640 of the option’s price is its time value, i.e. what you’ll pay for the chance that over the next 2 months it’s payoff will increase.  For a deep in the money call option, this is small compared to its intrinsic value.

In comparison, the out of the money $90 option has $0 intrinsic value.  So its $0.790 price is all time value, i.e. the chance that over 2 months the stock price will rise to above $90.

The Option Premium

<h3>Call Option Payoff</h3>
A call option is the right, but not the obligation, to buy an asset at a prespecified price on, or before, a prespecified date in the future.

This diagram shows the option's payoff as the underlying price changes. Above the strike price of $100, the payoff of the option is $1 for every $1 appreciation of the underlying. If the stock falls below the strike price at expiration, the option expires worthless. Therefore, a call option has unlimited upside potential, but limited downside.

<img class="aligncenter size-full wp-image-1183" title="call_payoff" src="https://financetrain.com/wp-content/uploads/2010/10/call_payoff.gif" alt="" width="580" height="410" />
<h3>Put Option Payoff</h3>
A put option is the right, but not the obligation, to sell an asset at a prespecified price on, or before, a prespecified date in the future. The payoff diagram of a put option looks like a mirror image of the call option (along the Y axis). Below the strike price of $100, the put option earns $1 for every $1 depreciation of the underlying. If the stock is above the strike at expiration, the put expires worthless.

<img class="aligncenter size-full wp-image-1184" title="put_payoff" src="https://financetrain.com/wp-content/uploads/2010/10/put_payoff.gif" alt="" width="574" height="406" />

Option Payoff Diagrams

These payoff diagrams show how to create synthetic option or underlying positions through combining calls, puts, and the underlying.

A long call and a short put position is similar to being long a stock. A long put and a short call position is similar to being short a stock. A long stock and a long put position is similar to being long a call option. A long call and a short stock position is similar to being long a put option.
<h3><strong>Call – Put = Long Stock</strong></h3>
<strong><img class="aligncenter size-full wp-image-1188" title="call-put" src="https://financetrain.com/wp-content/uploads/2010/10/call-put.png" alt="" width="464" height="337" />
</strong>
<h3><strong>Put – Call = Short Stock</strong></h3>
<p style="text-align: center;"><strong><img class="aligncenter size-full wp-image-1189" title="put-call" src="https://financetrain.com/wp-content/uploads/2010/10/put-call.png" alt="" width="478" height="356" />
</strong></p>

<h3><strong>Stock + Put = Call</strong></h3>
<p style="text-align: center;"><strong><img class="aligncenter size-full wp-image-1190" title="stock-put" src="https://financetrain.com/wp-content/uploads/2010/10/stock-put.png" alt="" width="462" height="344" />
</strong></p>

<h3><strong>Call – Stock = Put</strong></h3>
<p style="text-align: center;"><strong><img class="aligncenter size-full wp-image-1191" title="call-stock" src="https://financetrain.com/wp-content/uploads/2010/10/call-stock.png" alt="" width="479" height="342" />
</strong></p>

Options - Creating Synthetic Positions

The following video from the options institute at CBOE provides an introduction to equity options

Option volume continues to grow year over year. Traders or investors that do not use options in their portfolio may want to consider these additional tools. If you have already decided to begin using options in your trading, this is the perfect video for you! In this video the instructor covers the mechanics of buying and selling option contracts along with important factors to evaluate before entering your first option trade.

<iframe width="600" height="450" src="http://www.youtube.com/embed/MXxVtTwSiKo?rel=0" frameborder="0" allowfullscreen></iframe>

Overview of Equity Options - Video

Basics of Options

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COURSE

Basics of Options

Lessons

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