option

What Is An Option

A stock option is a contract which conveys to its holder the right, but not the

obligation, to buy or sell shares of the underlying security at a specified price on or

before a given date. This right is granted by the seller of the option.

There are two types of options, calls and puts. A call option gives its holder the right to

buy an underlying security, whereas a put option conveys the right to sell an

underlying security. For example, an American-style XYZ Corp. May 60 call entitles

the buyer to purchase 100 shares of XYZ Corp. common stock at $60 per share at any

time prior to the option's expiration date in May. Likewise, an American-style XYZ

Corp. May 60 put entitles the buyer to sell 100 shares of XYZ Corp. common stock at

$60 per share at any time prior to the option's expiration date in May.

Underlying Security

The specific stock on which an option contract is based is commonly referred to as the

underlying security. Options are categorized as derivative securities because their

value is derived in part from the value and characteristics of the underlying security. A

stock option contract's unit of trade is the number of shares of underlying stock which

are represented by that option. Generally speaking, stock options have a unit of trade

of 100 shares. This means that one option contract represents the right to buy or sell

100 shares of the underlying security.

Strike Price

The strike price, or exercise price, of an option is the specified share price at which the

shares of stock can be bought or sold by the holder, or buyer, of the option contract if

he exercises his right against a writer, or seller, of the option. To exercise your option

is to exercise your right to buy (in the case of a call) or sell (in the case of a put) the

underlying shares at the specified strike price of the option.

The strike price for an option is initially set at a price which is reasonably close to the

current share price of the underlying security. Additional or subsequent strike prices

are set at the following intervals: 2.5 points when the strike price to be set is $25 or

less; 5-points when the strike price to be set is over $25 through $200; and 10-points

when the strike price to be set is over $200. New strike prices are introduced when the

price of the underlying security rises to the highest, or falls to the lowest, strike price

currently available. The strike price, a fixed specification of an option contract, should

not be confused with the premium, the price at which the contract trades, which

fluctuates daily. If the strike price of a call option is less than the current market price

of the underlying security, the call is said to be in-the-money because the holder of this

call has the right to buy the stock at a price which is less than the price he would have

to pay to buy the stock in the stock market. Likewise, if a put option has a strike price

that is greater than the current market price of the underlying security, it is also said to

be in-the-money because the holder of this put has the right to sell the stock at a price

which is greater than the price he would receive selling the stock in the stock market.

The converse of in-the-money is, not surprisingly, out-of-the-money If the strike price

equals the current market price, the option is said to be at the-money.

Premium

Option buyers pay a price for the right to buy or sell the underlying security. This price

is called the option premium. The premium is paid to the writer, or seller, of the

option. In return, the writer of a call option is obligated to deliver the underlying

security (in return for the strike price per share) to an option buyer if the call is

exercised and, likewise, the writer of a put option is obligated to take delivery of the

underlying security (at a cost of the strike price per share) from an option buyer if the

put is exercised. Whether or not an option is ever exercised, the writer keeps the

premium. Premiums are quoted on a per share basis. Thus, a premium of 7/8

represents a premium payment of $87.50 per option contract ($0.875 x 100 shares).