The basics of options

Option contract

A stock option contract is an agreement between a buyer and a seller to buy or sell a share at a specific price within a certain period.

Calls and Puts

There are two types of option contracts: calls and puts. A call option gives the buyer the right to buy the underlying asset at a set price and obligates the seller of the call to sell the underlying asset at that price. A put option gives the buyer the right to sell the underlying asset at a set price and obligates the seller of the put to buy the underlying asset at that price.

Premium

The cash price that the buyer of the option pays to the seller of the option. For example, an option contract traded at a premium of $1 is worth $100, since each contract covers 100 shares.

Strike price

The strike price is the predetermined price at which the option contract can be exercised:

- For calls, when the price of the underlying shares rises above the strike price.

- For puts, when the price of the underlying shares falls below the strike price.

In / At / Out of the Money

In the Money

When an option contract is worth exercising, it is ‘in the money’.

A call is ‘in the money’ when the price of the underlying shares exceeds the strike price.

A put is ‘in the money’ when the price of the underlying shares falls below the strike price.

Buyers of options want the option contracts to be ‘in the money’.

At the Money

An option is ‘at the money’ when the market price equals the strike price.

Out of the Money

An option is ‘out of the money’ when it is not worth exercising.

Sellers of options want the option contracts to be ‘out of the money’.

Expiration date

Options have an expiration date that specifies the last day on which the option contract exists. American options allow buyers to exercise their rights at any time before and including the expiration day.

All contracts that are owned and at least $0.01 ‘in the money’ at expiration will be exercised automatically. Those ‘at’ or ‘out of the money’ at expiration will lapse.

Break-even

The break-even point is the point where the investor neither wins nor loses.

For calls, the break-even point is found by adding the strike price and the premium.

For puts, the break-even point is found by subtracting the premium from the strike price.

Options are complicated, high-risk products and are not suitable for all investors. You can lose all your invested capital.