An option contract gives the buyer of the option the right, but not the obligation to buy (call) or sell (put) the underlying asset at a specific price (strike price or exercise price) within a specific period of time (expiration date). As the price of the stock moves, the price of the stock option moves. At anytime, the option trader can go into the open market and exit the position. Almost all equity options expire on the third Friday of each month. Option sellers (naked sellers) are at the mercy of the option buyer. They have no rights, only obligations to buy (put seller) the underlying asset or sell it (call seller) if the right is exercised. Options are used for speculation; however, they are also used to hedge risk. The option strategy and the leverage used determines the risk. Each option contract represents 100 shares of the underlying stock or index. Stock options are settled with the physical delivery of the stock while index options are settled in cash. The price of the option is determined by a number of variables and there are many pricing models, the most popular being Black-Scholes. The time until expiration, interest rates, dividends, the volatility of the underlying stock, the relationship between the stock price and the strike price are all used to determine the price of the option contract. Options trade on exchanges and in some cases the option is listed on more than one exchange (multi-listed). Market Makers are professional traders who post option bid and ask prices for each option. They add liquidity to the market and in most instances, you would not be able to trade options without them. That’s because at any given moment, it’s unlikely that another trader is trying to execute the other side of your option trade. Options are less liquid than the underlying stock and the trading volume might be spread across 20 different options (strike prices, expiration months, puts/calls).
Stock Option Contract
August 27, 2008