Options allow traders to bet on the price movements of stocks without actually owning those stocks.
Karl Köhler via Unsplash; Canva
What Are Options Contracts and How Do They Work?
An options contract is a tradable security that grants its owner the right or “option” (but not the obligation) to buy or sell a predetermined amount of an underlying asset (usually 100 shares of stock) at a specific price (the contract’s “strike price”) on or before a certain date (the contract’s expiration date). Call options grant their owners the right to buy shares, while put options grant their owners the right to sell them.
Because options contracts derive both their value and their risk from un underlying asset (usually a stock), they are considered derivative securities, or simply “derivatives.” Other types of derivative contracts include futures, forward, and swaps.
Essentially, options contracts allow traders to bet on (and ideally, profit off of) the future price movements of stocks without actually having to own those stocks.
What Are the 2 Types of Options Contracts?
There are two different types of options contracts, and each endows its buyer with a different right.
Call Options
The owner (buyer) of a call option has the right to buy 100 shares of a stock from the option writer (seller) at the strike price outlined in the contract any time before the contract expires. Alternatively, they can resell the contract on the open market. Call options gain value when the price of the underlying stock goes up, so they are considered bullish.
Call Option Example
For instance, if an investor thinks the price of Apple stock is going to go up after its earnings call, they could buy a call option with a strike price close to Apple’s spot price (current market value) that expires a week after its earnings call is scheduled.
If the call goes well because Apple beats earnings estimates, and Apple’s stock price goes up as a result, the investor can then resell their call option for more than they paid for it or exercise it in order to buy 100 Apple shares at the contract’s strike price, which is now below market value. In other words, they can either resell their contract for a profit or buy 100 shares at a discount.
Put Options
The owner (buyer) of a put option has the right to sell 100 shares of a stock to the option writer (seller) at the strike price outlined in the contract any time before the contract expires. Alternatively, they can resell the contract on the open market. Put options gain value when the price of the underlying stock goes down, so they are considered bearish.
Put Option Example
For instance, if an investor thinks the price of Tesla stock is going to fall due to a chip shortage and impending supply-chain issues, they could buy a put option with a strike price close to Tesla’s spot price (current market value) that expires in a few of months.
If a chip shortage and supply-chain slowdowns do affect Tesla’s production and sales, and the stock price goes down as a result, the investor can then resell their put option for more than they paid for it or exercise it in order to sell 100 Tesla shares at the contract’s strike price, which is now above market value. In other words, they can either resell their contract for a profit or sell 100 shares for more than they’re worth, pocketing the difference.
What Is the Strike Price of an Option?
In an options contract, the strike price is the agreed-upon price at which the underlying security may be bought (in the case of a call option) or sold (in the case of a put option) by the option holder until or upon the expiration of the contract. The term strike price is used interchangeably with the term exercise price.
Intrinsic Value: Strike Price vs. Spot Price
An options contract’s spot price, on the other hand, is the current market value of the underlying stock or asset. This changes constantly, while the strike price remains the same. The relationship between an option’s strike price and spot price is part of what determines the contract’s value.
For instance, if the strike price of a call option is below its spot price, it has intrinsic value because it could be exercised in order to buy 100 shares of the underlying stock at below market value. Similarly, if the strike price of a put option is above its spot price, it has intrinsic value because it could be exercised in order to sell 100 shares of the underlying stock for more than it’s worth.
It’s important to remember that an option’s intrinsic value (the discount or markup at which shares could be bought or sold, respectively) is always included in its premium (the market price of the contract).
What Is an Option’s Premium?
An option’s premium is its market price, or how much a buyer would have to pay to own the contract—not the market price of the underlying stock. This price can change over time and is based on three factors: its intrinsic value, its time value, and the volatility of the underlying stock or asset.
Intrinsic value
An option has intrinsic value if it could be exercised to buy shares at a discount or sell them at a markup. You can think of an option’s intrinsic value as the difference between its strike price and its market price (if advantageous to the buyer).
In the case of a call, an option has intrinsic value if the strike price is below the market price. In the case of a put, an option has intrinsic value if the strike price is above the market price. As mentioned above, an option’s intrinsic value is always included in its premium.
For instance, if a call option’s strike price was below its spot price by $2, it would have $200 worth of intrinsic value ($2 * 100 shares), so its premium would be at least $200. If a call option’s strike price was above its spot price by $2, it would have no intrinsic value, so its premium would be determined entirely by its time value and the volatility of the underlying stock.
Time Value
The time value of an option contract is based on how long remains until the contract expires. The longer a contract has until expiration, the higher its time value. When a contract is approaching expiration, little time remains for the underlying asset to change in value, whereas when a contract has months until its expiration, the underlying asset has plenty of time to change in value.
Other factors aside, options have higher premiums the farther they are from expiration. It’s also important to remember that time value decreases more quickly the closer a contract gets to its expiration. In other words, it decreases exponentially rather than linearly—this effect is sometimes called “time decay.”
Volatility of the Underlying Asset
Volatility, sometimes measured via standard deviation, is the degree to which the underlying asset varies in price on a regular basis. The higher the underlying stock’s volatility, the higher an options contract’s premium, all other things being equal. The more a stock fluctuates in value, the more likely it is to move into or out of the money in a short period of time.
In the Money vs. Out of the Money
If an options contract has intrinsic value, it is considered “in the money,” and its intrinsic value is included in its premium. If an options contract does not have intrinsic value, it is considered “out of the money,” and its premium is based primarily on its time value and volatility, which together determine how likely the contract is to wind up “in the money” by the time it expires.
If the strike price of an contract is equal to its spot price (the underlying stock’s current market value), it is considered “at the money.”
