Options are available on a wide range of financial instruments. An option is not like a stock; an option should be viewed as an agreement between two people. An option can be created out of thin air, if the two parties can agree on the terms.
We will focus on stock options. A call option on a stock provides the option holder the right (but not the obligation) to purchase a stock at a fixed price up until a certain date. The key terms are:
- the strike price: the price at which the option holder can buy the stock
- expiration: the date on which the option expires
- premium: the price of the option
Call options come in a wide range of strike prices and expirations.
When an option’s strike price is the same as the price of the stock, the option is “at the money.” When the strike price of a call option is lower than the stock price, the option is “in the money.” Finally, when the strike price of a call option is higher than the stock price, the option is “out of the money.”
Expiration is self-explanatory. Expiration dates can range from a few days to years.
Options can be purchased or sold for a premium. The premium is set by supply and demand, through the actions of traders, investors and other market participants.
A person who purchases a call option can participate in the rise of the stock, but does not have to expose himself to the downside. If, before the option expires, the stock rises in value so that its price is higher than the strike price, the option holder can “exercise” the option and buy the stock at the strike price; then immediately turn around and sell the same stock at the higher market price. But, the investor has no obligation to buy the stock. Therefore, if the stock declines such that it is worth less than the exercise price, the call option investor can walk away and not take a loss.
If a call option offers the investor upside potential with limited downside, someone has to take the opposite side of the trade: downside potential with limited upside. No one in their right mind would take such a payoff pattern unless they were adequately compensated for the risk. In practice the option premium is sufficiently generous that the option writer (i.e., the option seller) feels he is more than compensated for the risk.