Option Basics And Terminology

Options can be created on almost any asset, and they are now actively traded on a wide range of assets such as stocks, bonds, and currencies. It is easiest to learn the basics of options by looking at options on stocks. The concepts can then be extended to options on other kinds of assets.

There are two types of options: calls and puts. A call option on a stock gives the buyer or holder the right (but not the obligation) to buy the stock at a par-

ticular price within a specified period of time. For example, if you buy a 3-month call option on General Electric (GE) stock with an exercise price of $30 for a price of $3, you will have the right to buy from the option's seller (also called the writer) one stock of GE for the exercise price of $30 anytime during the 3-month period, irrespective of the stock's price at that time.

In options terminology, the GE stock is called the underlying security or asset, the $30 price at which you have the right to buy the stock is called the exercise or strike price, and the $3 you paid to buy the call option is called the option or call premium. Since the right the call gives you is valid for a period of 3 months, the call is said to have a life or time until expiration of 3 months. The process of purchasing the GE stock by paying the $30 exercise price, if and when you choose to do so, is called exercising the call.

If you have the right to exercise an option at any time during its life (as we have been assuming), then it is called an American option. If, however, you have the right to exercise an option only at the end of its life, then it is called a European option. (If you have difficulty remembering which is which, use this mnemonic: American Always, European at Expiration.)

If instead of a call option you had bought an American put option on a GE stock under the same terms, then you would have the right to sell a GE stock at any time during the 3-month period at $30 irrespective of the price of the stock at that time. (All other terminology remains the same.)

Although almost all options people trade are American options, it is easier to first analyze European options and then consider American options as an extension. This is the approach we will take.

Why would you buy a call option? Suppose the GE call you bought was a European call and GE stock goes up to $50 at the time the call expires. Then you will be able to exercise your call to buy the stock for $30 and immediately sell it in the market for $50. This will produce a gross profit of $20, or a net profit of $17, after deducting the call premium you paid. The $20 is called the call's payoff.

For you to make money on the call, GE stock will have to be above $33 at the time of the call's expiration. Beyond that, the higher the price of GE stock at the call's expiration, the higher your profit will be. Theoretically, your profit potential is unlimited. However, if GE stock price is below $30 at the call's expiration, then you will not exercise the call because you do not have any obligation to do so and you would not want to buy GE stock at $30 if it is available in the market for less. Your maximum loss is therefore limited to the $3 premium you paid.

It should now be clear that people buy call options because they offer highly leveraged opportunities to profit from the rise in a stock's price with the downside risk limited to the premium paid. Because puts work exactly the opposite way, they offer highly leveraged opportunities to profit from the fall in a stock's price, with the downside risk limited to the premium paid. So if you expect a stock to go up, you will buy calls, and if you expect it to go down, you will buy puts.

What we mean by highly leveraged is that on equal dollar investments, an option investor has the potential to make significantly higher profits on the options than on the underlying asset. This applies to losses as well, except that the loss on an option is limited to the premium paid. (You will be able to see all of this clearly using some of the models we will develop.)

One other difference between calls and puts, mostly of theoretical interest, is that there is no limit on a call's profit potential because there is no limit on how high a stock's price can go. A put's profit potential is limited because a stock's price can never fall below zero.

Here are a few other option terms you should be familiar with. Whenever an option's exercise price equals the stock price, the option is said to be at-the-money. If the exercise price is lower than the stock price, then a call option is said to be in-the-money and a put option is said to be out-of-the-money, because you could make a profit by immediately exercising the call but not the put. When the exercise price is above the stock's price, then the call is out-of-the-money and the put is in-the-money. Over its life, a call or a put can fluctuate among these different stages as the price of the stock fluctuates, but you would exercise an European call only if it is in-the-money at the time of expiration. If an option is in the money, the (gross) amount of money you can make by exercising it immediately is called the option's intrinsic value. At other times, the intrinsic value is zero. Most of the time during its life, an option sells for more than its intrinsic value.

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