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An option is a financial contract between two parties -
the buyer (holder) and seller (writer). The option gives the
holder the right, and the writer the
obligation, to buy or sell a predetermined amount of a
certain stock (equity option) at a specified
price (strike price), on or before a specified date (expiry date).
Options can be traded in things such as stocks, indexes, commodities
and other financial instruments, but this
article deals with equity and index options.
The
holder of an option has a long position, while the writer of an option
has a short position.
Options are traded in contracts, with each contract normally
representing 100 shares of the underlying stock.
American-style options can be exercised by the holder at any time
prior to expiry. European-style options can only be exercised
for a specified period of time prior to expiry. According to the
Chicago Board Options Exchange (CBOE), all equity options currently
traded on US exchanges, and some index options, are American-style,
while many index options are European-style.
Call
option
A call is an option which gives
 | the holder the right to buy a specified number of shares of a certain
stock at the strike price on or before expiry date, and |
| the writer the obligation
to sell the shares at the strike price, on or
before expiry date, at the option of the holder. |
Calls are purchased by those who
expect the share price to be above the strike
price at expiry date. Calls are sold by
those who expect the share price to be below the
strike price at expiry date.
A call is in the money when the current market value
of the stock is above the strike price. It is out of the
money when the current market value is below the strike price, and
at the money when the two amounts are equal.
The writer of a call can choose to buy back the call on or before
expiry date, if it has not yet been exercised by the holder.
The holder of a call can choose to sell the call on or before
expiry date.
Covered vs. uncovered (naked) call
A call is covered when the writer of
the call owns the underlying shares. If the writer does not own
the underlying shares, the call is uncovered. Covered calls can
be written in a registered account such as an RRSP, but uncovered
calls cannot.
Put
option
A put is an option which gives
| the
holder the right to sell a specified number of shares of a
certain stock at the strike price on or before the expiry date, and |
| the writer the obligation
to buy the shares at the strike price on or before
the expiry date, at the option of the holder. |
Puts are purchased by those who
expect the share price to be below the strike
price at expiry date. Puts are sold by
those who expect the share price to be above the
strike price at expiry date.
A put option is in the money when the current market value
of the stock is below the strike price. It is out of the
money when the current market value is above the strike price, and
at the money when the two amounts are equal.
The writer of a put can choose to buy back the put on or before
expiry date, if it has not yet been exercised by the holder.
The holder of a put can choose to sell the put on or before expiry
date.
Covered vs. uncovered (naked) put
A put is covered if the writer of the put:
| has cash on deposit in an amount equal to the exercise value
of the put, or |
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has a short position in the underlying
shares |
Otherwise, the put is uncovered.
Learning about options
The Chicago
Board Options Exchange (CBOE) is a good source for information on
options. They have online tutorials and courses, delayed quotes
for stocks and options, and historical price information. They
also have downloadable
quotes, which can be imported into a spreadsheet program.
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