What are options?
In the simplest way explicable, an option is a contract to buy or sell a specific security.
In equity options, the underlying security or the security we are trading a contract of is typically a stock, exchange traded fund, or a similar financial product.
These options contracts have what is known as an expiration date. At the time of expiration on this expiration date, the options contract no longer has value and ceases to exist.
There are two types of options contracts, call and puts. You can buy or sell either type of options contract, deciding when to buy or sell a call or put depends on what strategy you are trading by. We will go over calls and puts more in depth in the following article.
Buying vs. Selling Options
In options trading, if a call is bought, you are buying the right to purchase the underlying security at what is known as the strike price by or before expiration. The owner of this contract also has the right to sell this options contract to another buyer or let it expire worthless on the expiration date. This is the same for when puts are bought, if a put is bought, you are buying the right to purchase the underlying security at what is known as the strike price by or before expiration. The owner of this contract also has the right to sell this options contract to another buyer or let it expire worthless on the expiration date.
Selling an option to open which is also known as writing an option is different from buying options contracts. When you sell a call option to open you are obligated to sell the underlying security at the strike price if exercised. When you sell a put to open, you are obligated to buy the underlying security if it is exercised. When you sell a contract to open, you must be aware that you have no control over when that contract is exercised and that it can be exercised at any time until the expiration date. When buying options, the buyer can sell the contract back to the market rather than exercising the contract. When selling/writing options to open, the writer can purchase a contract that offsets the contract they sold to open to end their obligation in the terms of the contract that has not yet been executed.
If you are still confused on what the difference between buying vs. selling options contracts are, feel free to ask me questions using the message box in the bottom right hand corner. Do not stress on it too much as we will go over these terms in more detail in the following articles, this article is more so introductory.
What is premium?
When you buy an options contract, the price it was purchased at is what is known as premium. If you sell an options contract, the amount you receive is what is known as premium. In an options transaction, the price that the buyer and seller agree upon is the price for that transaction.
When you buy options contracts you start with what is known as a net debit. A net debit means that you have paid a certain a amount that can possibly be lost unless you sell your options contract back to the market at a profit or exercise it. Net profit is calculated by any income made subtracted by the premium paid. When you sell an options contract, you start with what is known as a net credit. A net credit means that you collect the premium, if the options is never exercised you keep that amount in premium. Net profit is the premium amount unless you are obligated to buy/sell the underlying security if it is exercised.
Why do options hold value and how are they priced?
The value of options is derived from the likelihood of the options contract meeting the expectations of the buyer or seller. This likelihood is judged by the options ability to be in-the-money or out-the-money at the time of expiry (more about ITM vs. OTM can be found here).
An options contract's value has two parts. These two parts include intrinsic value and time value, intrinsic value is the amount that the options contract is in-the-money and time value is determined by how long the market conditions are in your favor. If an options contract is not in-the-money by the time of expiration, the options contract is worthless.
Several different variables affect the pricing of an options contract, supply and demand of the market being one of the largest impacting variables. The status of the overall market as well as the economy play an important role in the pricing of an options contract. There is several different variables that can be used to judge the pricing of an options contract and we will delve into those in the following articles.
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