Options are contracts that offer investors the potential to make money on changes in the value of, say, a stock without actually owning the stock. Of course, one can also lose money trading options. Options are considered derivatives because they derive their value from the price of another asset, called the underlying asset. In the case of options, the underlying asset can be single stocks, exchange-traded funds (ETFs), the value of an index, debt securities (like bonds or index-linked notes) or foreign currencies.
Options give the purchaser (also called the option holder) the right, but not the obligation, to buy or sell the underlying asset at a fixed price, known as the strike price, within a specific period of time. The seller (also known as the writer) of options accepts the obligation to buy or sell the underlying asset if the contract is assigned, meaning the seller’s brokerage firm requires the seller to meet the obligations spelled out in the contract.
Options come in two types: call options and put options. Call options give the holder the right to buy the underlying asset, or the value of the underlying asset, in the case of index options. The seller of a call option accepts, in exchange for the premium the holder pays, an obligation to sell the stock (or the value of the underlying asset) at the agreed upon strike price if assigned.
With put options, the holder obtains the right to sell a stock, and the seller takes on the obligation to buy the stock. If the contract is assigned, the seller of a put option must buy the underlying asset at the strike price.
Options are complex instruments that can play a number of different roles within an investment portfolio, from helping investors manage risk to increasing income from current stock holdings. Buying and selling options can be risky, and trading the product requires specific approval from an investor’s brokerage firm.
Beyond puts and calls, options contracts vary in their underlying assets and longevity.
Although the types of assets on which U.S. investors can purchase options include equities, indexes, debt securities and foreign currencies, the focus here is mainly on equity and index options.
Equity Options: Equity options have shares of stocks and exchange-traded funds (ETFs) as their underlying asset. If you exercise an equity option, you buy or sell shares of that underlying stock or ETF depending on whether you purchased a call or a put. Equity options trade “American-style,” which means you (as the holder of the contract) can exercise it at any time between the date of purchase and the expiration date. It’s important to note that different brokerage firms may have different exercise cut-off times. Consult with your brokerage firm or investment professional to ensure that you don’t miss that deadline.
Index Options: Index options have the value of an underlying index, such as the S&P 500 or the Chicago Board Options Exchange’s Volatility Index (VIX), as the underlying asset. Index options are cash-settled, which means exercising an index option results in a cash payment instead of the exchange of a security, such as an index future. Index options generally trade “European-style,” which means the settlement process is done at expiration only, which can be based on the value of the index at market open or market close.
The differences between equity options and index options are most important to consider and understand when it comes to indexes for which there are also ETFs. For example, while SPDR S&P 500 options, or SPY options, which are options tied to an ETF that tracks the S&P 500, are American-style options that settle in shares of SPY, S&P 500 Index options, or SPX options, which are tied to S&P 500 futures contracts, are European-style options that settle for cash.
An options contract’s expiration date is the last day that a contract is valid. Before this date, the holder of an options contract can choose to exercise the option (in the case of American-style contracts), trade the contract to close the position or let the contract expire worthless.
Generally, standardized equity options that are in-the-money—meaning the market price of the underlying security is above the strike price of a call option or below the strike price of a put—will automatically be exercised at expiration. For call options, that means the cost associated with doing so (in other words, the money to buy 100 shares of the underlying stock) will be due at that time.
Below is a list of the most common types of options expirations.
Daily Options: While a similar strategy could be employed with other duration types, new zero-day-to-expiration (0DTE) options are same-day contracts that expire within 24 hours of purchase.
Monthly Options: Options are traditionally structured on a monthly basis, with contracts for each month of the year expiring on the third Friday of every month.
Weekly Options: Weekly options are short-term contracts that are usually listed with at least one week until expiration. Like monthly contracts, they expire on Fridays. Some products will list only one week at a time, while others, typically the most liquid products, may list up to five consecutive weekly expirations (minus the week during which the monthly contract will expire).
Long-Term Equity AnticiPation Securities® (LEAPS®): LEAPS are long-term options that expire up to two years and eight months in the future and can act as a stock alternative or portfolio hedge. LEAPS trade just like other listed options but may have limited availability and have unique risks when it comes to their pricing and time premium erosion.
Binary Options: Unlike other types of options contracts, binary options are all-or-nothing propositions. Trading binary options can be an extremely risky proposition. Trading binary options is made even riskier by fraudulent schemes, many of which originate outside the U.S.
Before you can trade options, your brokerage firm must approve your account for a specific level of options trading since some strategies involve substantial risk. In order to be approved for trading, you’ll need to fill out your firm’s options agreement. This policy is designed to protect investors from trading beyond their abilities or financial means and to protect brokerage firms against potential defaults on margin accounts. Ask your firm to learn more about their particular levels of approval and what it takes to be approved for different levels.
When approved for options trading, there are a number of things of which you need to be aware. Options have a strike price, the specific price at which the contract may be exercised, and an expiration date, the date by which the purchaser (holder) of the contract must exercise the contract should they wish to do so. A standard-size options contract is equal to 100 shares of the underlying security.
The price at which an option is purchased is called the premium. A number of factors impact an option’s premium, and an option’s premium can change often.
All options, both puts and calls, can be bought and sold. To initiate an options trade, you must either enter an opening purchase or an opening sale. In an opening purchase trade, an investor opens a position by buying a call or a put. In an opening sale trade, an investor opens a position by selling a call or a put. To get out of a trade, an investor must do the reverse. An investor who previously purchased an option can exit the trade with a closing sale of the same contract series. An investor who previously sold an option can exit the trade with a closing purchase.
Options are securities that can go up and down based on a variety of factors. As a derivative product, one of the main drivers of an option’s value is the underlying security or index. The purchaser of a contract can make money if the value of the underlying security or index rises above (in the case of a call) or falls below (in the case of a put) the strike price of their options contract by more than the premium paid. The purchaser will only realize their gains if they sell their option position or the position resulting from the exercise of their rights under the contract.
The seller of an option will only realize their gains if they buy back the contract for less than the sale price or if the contract expires worthless. A contract expires worthless when the price of the underlying security or index remains below (in the case of a call) or above (in the case of a put) the strike price. Additionally, the seller may also realize gains if the seller of the contract is able to close the position resulting from the assignment at a favorable price.
The prices of stocks and indexes change all the time, as do the value of options contracts. Options investors can have a paper profit one day and a paper loss the next. Any potential profits are not guaranteed until a closing transaction is completed or the contract reaches expiration.
For the purchaser of an option, the premium paid is your maximum loss. For the seller of an option, the premium you receive at the time of the sale is your maximum profit. If the seller of a contract is assigned, they may lose money. In the case of an uncovered, or naked, call, where an investor sells a call option without owning the underlying stock, the maximum loss is theoretically unlimited. That’s because while purchasers of options have the right, but not the obligation, to exercise the options contract that they purchased, investors that sell—or write—contracts, have the obligation to buy or sell shares at the strike price if assigned. Learn more about options assignment.
Options investors can bound their potential losses (and potential gains) by executing strategies with multiple “legs,” or with multiple contracts on the same security, but doing so is complicated and comes with its own risks. One risk includes one leg of the position being closed automatically by the investor’s brokerage firm due to certain risk factors such as insufficient funds. This can happen if an investor’s account lacks the funds to follow through with a transaction should they be assigned and required to purchase shares. Not all investors will be approved for such strategies.
Trading options can come with significant risks. These risks vary greatly based on whether you’re buying or selling options and can include significant risk of loss beyond your initial investment.
That’s in part because options can provide leverage. For a premium that’s small relative to the underlying security or index, investors can gain exposure to a relatively large contract value since one contract equates to 100 shares of the underlying asset. On the upside, investors can see a large percentage gain from small percentage moves in the underlying asset. But this leverage can be magnified to the downside as well.
The risks of buying and selling options are covered in detail in the Characteristics and Risks of Standardized Options—a disclosure document that brokerage firms are required to distribute to options customers—but below is also a brief overview.
Expiration Risk: In-the-money options contracts are generally automatically exercised at expiration. But to exercise a call option, the owner of the contract must have the funds to do so. Because one options contract is tied to 100 shares of stock, exercising a call can require substantial funds. For a contract with a strike price of $100, the owner of a call would need $10,000 to exercise.
Assignment Risk: The seller of an options contract may be assigned and required to fulfill the terms of the contract by either selling or buying the underlying security at the strike price. For the sellers of equity options, assignment can happen at any time.
Dividend Risk: There is a higher risk of assignment the day before a stock’s ex-dividend date, the date a stock begins trading without the value of its dividend payment included in the price. This is because holders of in-the-money positions might exercise early to benefit from that payout. The same risk exists for other corporate actions that might impact the price of the underlying security, such as a merger or acquisition.
Margin Risk: There are margin requirements related to some short options positions. If the value of the underlying security moves against the seller of that position, or if there is significant volatility in the underlying security or related markets, the investor might be required to deposit significant additional funds. If those funds are not deposited, the firm has the right to liquidate the options position and other securities positions without notice. There are also margin risks that relate to being an options holder.
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