Call Option is the right to buy a stock at a certain price. The strike price is the price where the buyer of the option has the right to exercise, and thus, purchase the stock. The buyer of an option is generally bullish because a buyer believes the stock price will eventually exceed the strike price prior to expiration. The seller of a Call Option, has the obligation to sell the stock to the buyer of the call option at the strike price if the option is exercised. Since the seller received the premium, a seller is generally bearish and believes the stock price will not achieve the strike price, thus having the option expire worthless. A Call Option is generally abbreviated with the letter C.
Put Option is the right to sell a stock at a certain price. It is the exact opposite of a Call option in many ways. The strike price is the price where the buyer of the option has the right to exercise, and thus, sell the stock at this price. The buyer of this option is generally bearish and will use a put option as a hedge to existing stock or to profit from the decline of a stock. The seller of a Put Option is generally bullish because a seller wants the stock price to be higher than the strike price. In this case, the option will become worthless at expiration. If at expiration, the strike price is higher than the stock price, the buyer of the put option can “put” the stock to the seller and sell the stock at the strike price and immediately buy it at the current stock price. A Put Option is generally abbreviated with the letter P.
Premium is the actual cost of the option that the buyer of the option pays to the seller of the option. In some cases, the option may have both intrinsic value and time value.
Expiration is the last day to either exercise the option or to close out one’s option position. For most ordinary options, this expiration occurs on the third Saturday of every month, with the third Friday being the last trading day for options.
Open Interest is simply described as the number of open buy orders. If Person A buys 5 options from Person B, the open interest is 5. In addition, if Person C buys 10 options from Person D, the open interest is now 15. If Person A sells 3 options and Person D buys them, the new open interest is 12. In essence, Person A has close his position by 3 by having an offsetting transaction with Person D. If Person E buys 5 contracts from Person C, the open interest remains at 12 because Person C has an offsetting transaction of 5 while Person E establishes a new position. There is no net change in the number of open buy orders.
Options are a type of derivative investment that allows one to either leverage or hedge assets. The main type of option available in the United States is an American Option. An American Option is different from a European Option, in that one can choose when to exercise the option. Whether there is 3 days left in an option or 3 months, the holder of an American Option can choose when to exercise, give the option is “in-the-money”. With an European Option, one can only exercise the option at the expiration date. As we will see later, if we have an American Option that is “in-the-money,” we will want to hold onto the option as long as possible.
Before we continue, there are some terminology we must review. When trading American Options, one must be familiar with the terms Stock/Market Price, Strike/Exercise Price, Premium, Expiration, Open Interest, Call Option, Put Option, Buyer/Long, Seller/Short.
The Stock or Market price is just that. It is the current trading price for the underlying stock.
The Strike Price is the price where the option must be in order for the option to have any intrinsic value. From Wikipedia, it is also, “The fixed price at which the owner of an option can purchase, in the case of a call, or sell, in the case of a put, the underlying security or commodity.” This term is generally abbreviated with the letter X.
