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Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options

1 What is an option?
2 What is an option buyer?
3 What is an option premium?
4 What is the expiration date?
5 What is the exercise of an option?
6 What is a strike price?
7 Where are options traded?
8 What happens if the price of the underlying security increases?
9 What do I have if I buy a call?
10 What is a call?
11 What are the types of options?
12 If I buy an option contract and the price of the underlying security moves in a favorable direction, do I have to exercise the option?
13 What are the choices that an option buyer has?
14 What does buying or selling an option really mean?
15 What is an option writer?
16 What is a covered call?
17 Why would I sell a call contract?
18 What happens if I write (sell) a call contract?
19 How do I go about exercising a call that I own?
20 What happens if the price of the underlying security remains the same or decreases?
21 What happens if I want to exercise a put that I own?
22 What happens if the price of the underlying security decreases?
23 Why would I buy a put?
24 What do I have if I buy a put?
25 What is a put?
26 Can I sell a call without owning the underlying stock?
27 What are some of the terms I need to know if I am going to trade in options?
28 When is the settlement date for option trades?
29 Will I be issued a certificate for an option contract?
30 Why would I sell a put contract?
31 When might an option contract be considered insurance?
32 What does the time value of an option mean?
33 Why do in-the-money options sell at premium above their intrinsic value?
34 What is an option's intrinsic value?
35 What does out of the money mean?
36 What does in the money mean?
37 What are index options?
38 What is an options spread?
39 I have heard of options straddle. What are they?
40 I have heard of options combinations. What are they?
41 What is the risk in setting calls against a stock I currently own?
42 Do options on foreign currencies trade?
43 Can I invest in interest-rate options?
44 If I buy one OEX put option, what do I have?
45 If I buy one OEX call option, what do I have?
46 How do OEX contracts trade?
47 What is the expiration date?
48 What is the prospectus?
49 What is an option agreement?
50 What is an option disclosure statement?

 

Q. What is an option?
A. An option is a contract giving the owner the right to either buy or sell something (in this case a security), at a specified price (the strike or exercise price), before a specified deadline (the expiration date).

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Q. What is an option buyer?

A. An option buyer is an investor who pays the premium and acquires the rights that the particular option contract carries. He or she may be said to be long the option.

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Q. What is an option premium?

A. An option premium is the amount of money paid by a buyer, or received by a seller, for an option contract. When the underlying security is common stock, in most cases one option contract covers 100 shares of the underlying stock, and the premium quoted is the premium per share of stock controlled, not the premium for the entire contract. When buying options, you must pay the premium in full plus commissions. The premium is equal to the intrinsic value of the option plus a time value.

Example: If the premium (price) of an option contract is 4, the amount you would have to pay to control (have the right to buy or sell) 100 shares would be $400. If you were to write or sell the option, you would receive $400.

(a) (b) (c) (d) (e)

IBM Nov 60 call @ 4

    1. The underlying stock: IBM
    2. The expiration month: November
    3. The strike price: $60
    4. The type of contract (put or call): Call
    5. The premium: $4

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Q. What is the expiration date?

A. The expiration date is the date on which an option expires. If the owner of an option does not exercise or sell the option by the expiration date, it becomes worthless. Most option contracts have an expiration date of around ninety days from the time they start trading. All listed options expire at 11:59 P.M. on the Saturday following the third Friday of the expiration month.

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Q. What is the exercise of an option?

A. The exercise of an option means that the owner of the contract exercises his or her rights. In this case, the seller of the contract must fulfill his or her obligation under the contract.

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Q. What is a strike price?

A. The strike price, also referred to as the exercise price, of an option contract is the price at which the owner has the option, or right, to buy or sell the underlying security. Strike prices are established by the exchange on which the options are traded. For each underlying security, there will be several strike prices clustered around the price of the underlying security at the time the options are first traded. As the range within which the underlying security trades moves up or down, the exchange will establish new contracts with strike price reflecting current prices of the underlying security.

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Q. Where are options traded?

A. Options are traded on the following exchanges:

  • Chicago Board Options Exchange (CBOE).
  • American exchange.
  • Philadelphia exchange.
  • Pacific exchange.
  • New York Stock Exchange.

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Q. What happens if the price of the underlying security increases?

A. If the price of the underlying security increases, there are two things you can do: you can exercise the option, or you can sell it. If you exercise the option, you must pay the full strike price of the underlying security plus a commission; then you can either sell the security at the higher market price (less commission). If you sell the option, you will make a profit equal to the increase in the price of the call-which, because of the time value, is not necessarily the same as the increase in the price of the underlying security.

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Q. What do I have if I buy a call?

A. If you buy a call, you have the right to buy the underlying security at the strike price at any time before the expiration date.

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Q. What is a call?

A. A call is a contract giving you the right to buy a security. In the case of an option on common stock, it is a contract giving you the right to buy 100 shares of a stock at a specified price before or on a specified date.

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Q. What are the types of options?
A. There are two types of options: calls and puts.
  • Buying a call gives you the right to buy the underlying security.
  • Buying a put gives you the right to sell the underlying security.
  • Selling a call gives you the obligation to sell the underlying security if the buyer of the option wishes to buy it.
  • Selling a put gives you the obligation to buy the underlying security if the buyer of the option wishes to sell it.

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Q. If I buy an option contract and the price of the underlying security moves in a favorable direction, do I have to exercise the option?

A. No. You can sell your option contract. This is called closing the contract.

Note: If you are the seller of a contract and the price of the underlying stock starts moving in a direction that puts you in a loss position, you may want to buy an option contract to close your position and cut your possible losses.

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Q. What are the choices that an option buyer has?

A. Option buyers have three choices:

  • Exercise the option.
  • Let the option expire worthless.
  • Sell (or close) the option contract before the expiration date.

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Q. What does buying or selling an option really mean?

A. Buying an option gives you rights until the expiration date. Selling an option imposes obligations on you until the expiration date.

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Q. What is an option writer?

A. An option writer, or seller, is an investor who receives the premium and is obligated to perform the responsibilities that the particular option contract carries. He or she may be said to be short the option.

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Q. What is a covered call?

A. A writer, or seller, of call options against stocks he or she already owns is said to be writing a covered call. In this case, the risk of selling a call is that you may be required to sell your stock if the call owner exercises his or her option. This is referred to as having your stock called away.

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Q. Why would I sell a call contract?

A. The basic reason for selling a call contract is to increase your return on a security whose price you expect to remain the same or decline during the life of the contract. The seller receives the premiums paid by the buyer and, in return, agrees to deliver the underlying stock if the stock price rises above the strike price and the option is exercised. If the option writer is correct and the stock price does not rise, the premium provides him or her with an increased rate of return. Other objectives for selling calls might be:

  • To hedge some of the risk on a stock position.
  • To Speculate that a stock's price will not go up.

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Q. What happens if I write (sell) a call contract?

A. If you are the writer, or seller, of a call contract, you have the obligation to sell 100 shares of the underlying security at the strike price up to the expiration date if the buyer chooses to exercise the option.

Example: If you write (sell) one IBM November 50 call at $4, up to the expiration date of the contract in November, you have the obligation to deliver 100 shares of IBM stock if the call buyer exercises the option. You receive $400 ($4 times 100 shares) less commissions as the premium for selling this contract. If a call buyer does exercise the option, you have, in effect, sold 100 shares of IBM stock for $5,400 ($5,000 [$50 times 100 shares] for the stock plus the $400 premium). If the call buyer does not exercise the option before expiration, you have earned $400.

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Q. How do I go about exercising a call that I own?

A. If you own a call contract and the price of the underlying stock has increased, you can request your broker to exercise your contract. You will be buying 100 shares of the underlying stock for the strike price plus a commission.

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Q. What happens if the price of the underlying security remains the same or decreases?

A. If the price of the underlying security has not increased sufficiently by the expiration date, you would not exercise your option; it would expire worthless. Your only loss would be the premium you paid for the option plus the commission.

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Q. What happens if I want to exercise a put that I own?

A. If you own a put contract and the price of the underlying stock has declined, you can request your broker to exercise your contract. You will then be selling 100 shares of the underlying stock for the strike price less a commission.

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Q. What happens if the price of the underlying security decreases?

A. If the price of the underlying security decreases, there are two things you can do: you can exercise the option, you will receive the strike price for the underlying security less a commission; If you sell the option, you will make a profit equal to the increase in the price of the put.

Example: If you buy one IBM December 60 put at $2 1/2, you own the right to sell 100 shares of IBM at $60 per share at any time before the option expires in December. The cost of the contract is $250 ($2 1/2 times 100 shares).

If the price of IBM decreases to $52 by the expiration date, you could exercise your option and sell 100 shares at $60 per share less commission. (Note: your true proceeds would be $57.50 per share-$60 less the premium of $2 1/2). Alternatively, instead of selling your shares, you could simply sell your contract, since its value would have risen as the value of the common stock fell. In this example, it should have risen to about $8 (depending on the time value), so you could sell it for $8 and realize a profit of $5.50 ($8 less $2 1/2 cost) per share.

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Q. Why would I buy a put?

A. There are several reasons why you might buy a put, but one of the most popular is to guard against a possible decline in the price of a stock that you own. This is an alternative to selling (writing) a call against the stock. By buying the put instead, you have the right to sell your stock, not an obligation to do so.

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Q. What do I have if I buy a put?

A. If you buy a put, you have the right to sell the specified security at the strike price at any time before the expiration date.

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Q. What is a put?

A. A put is a contract giving the buyer the right to sell a security. In the case of an option on common stock, it is a contract giving the buyer the right to sell 100 shares of the underlying stock at a specified price before or on a specified date.

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Q. Can I sell a call without owning the underlying stock?

A. Yes. You may write (sell) a call without owning the underlying stock. Doing so is called writing a naked call (the opposite of a covered call). You run the risk that the stock price will increase sharply, leaving you in the position of having to deliver shares of a greatly appreciated stock that you do not own. Writing naked calls is not appropriate for the average investor because of this high risk.

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Q. What are some of the terms I need to know if I am going to trade in options?

A. If you decide to invest in options, some of the terms you should know are:

  • Opening transaction.
  • Closing transaction.
  • In the money.
  • Out of the money.

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Q. When is the settlement date for option trades?

A. Unlike stock and bond transactions, option transactions settle the day after the trade date. For this reason, an option investor should have a cash reserve or a money market fund at the brokerage firm.

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Q. Will I be issued a certificate for an option contract?

A. No. Because options are very short-time instruments, the issuance of certificates would not be practical.

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Q. Why would I sell a put contract?

A. The most common reason to sell a put contract is to increase your income by receiving the premium. As a seller of a put contract, you would be betting that the stock price would continue to rise and that you would keep the premium. If you were forced to buy the stock, your net cost would be lowered by the amount of the premium you received.

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Q. When might an option contract be considered insurance?

A. Options are generally thought of as speculative investments. They are not investments that are usually suitable for novice investors. However, when an option is used in conjunction with a stock holding, it may be thought of as insurance.

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Q. What does the time value of an option mean?

A. The time value of an option contract refers to the fact that an option contract is a wasting asset. The amount of time left in an option contract has a value to the buyer of the option. As the expiration date draws nearer, the time value diminishes. A buyer is usually willing to pay more for a contract that has a longer time outstanding than for one that is about to expire.

How time value enters into the pricing of an option is a complex subject and is beyond the scope of this FAQs page. However, in general, it is safe to say that as the expiration date gets closer, option contracts tend to sell near or at their intrinsic value.

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Q. Why do in-the-money options sell at premium above their intrinsic value?

A. The premium for an in-the-money option will reflect a time value as well as the intrinsic value.

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Q. What is an option's intrinsic value?

A. When an option is in the money, the difference between the strike price and the stock price is said to be the option's intrinsic value. Out-of-the-money contracts have no intrinsic value.

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Q. What does out of the money mean?

A. A call is said to be out of the money when the price of the underlying stock is lower than the strike price of the call.

A put is said to be out of the money when the price of the underlying stock is higher than the strike price of the put.

Market price of  Underlying Stock Put Call

Above strike price Out of the money In the money

Below strike price In the money Out of the money

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Q. What does in the money mean?

A. A call option contract is said to be in the money when the market price of the underlying stock is higher than the strike price of the option. For example, an IBM November 70 call is in the money by 10 points when the price of IBM stock is at $80.

A put option contract is said to be in the money when the stock price is lower than the strike price of the option. For example, and IBM November 70 put is in the money by 10 points when the stock is selling for $60.

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Q. What are index options?

A. Index options are a type of instrument developed several years ago to allow investors to purchase or sell options on a group of securities intended to reflect movement in the market or a particular industry, not a particular stock. The investor has to be right only on the direction of the market, not the direction of an individual stock.

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Q. What is an options spread?

A. An option spread is a strategy in which an option trader will simultaneously buy one option position on an underlying stock and sell a different option on the same stock. Usually, the two positions will have different strike prices, expiration dates, or both. Both positions may be calls, or both may be puts.

Example: You could buy one IBM December 50 put and sell one IBM March 55 put.

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Q. I have heard of options straddle. What are they?

A. A straddle is the buying or selling of both a put and a call with the same exercise price and expiration date on the underlying stock. The buyer has locked in a price at which he or she can either buy or sell the underlying stock. The buyer is betting on the stock's price volatility. All that the buyer needs in order to make a profit is a large enough movement in the price of the underlying stock in either direction.

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Q. I have heard of options combinations. What are they?

A. Option combinations are similar to straddles except that the expiration dates or strike prices will often be different.

Example: You could buy one IBM January 50 call and one IBM February 60 put.

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Q. What is the risk in selling calls against a stock I currently own?
A. The risk in selling calls against a stock you currently own is that if the price of the stock increases beyond a certain point, the owner of the calls will exercise the options. You will have to either deliver the stock from your portfolio or buy stock in the open market to make delivery.

If you deliver stock from your own portfolio, you will be taxed on any profit. You will have a capital gain of the difference between what you paid for the stock and the exercise price.

If you want to avoid the capital gain, you may purchase shares of the stock after you receive the call notice to make delivery. This allows you to keep your original shares.

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Q. Do options on foreign currencies trade?

A. Yes. Options based on the value of several foreign currencies trade on the options exchanges. The valuation of options on foreign currencies is very difficult, and so these options should be avoided by all but very experienced or professional investors.

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Q. Can I invest in interest-rate options?

A. Yes. There are various interest-rate option contracts that trade on the American Stock Exchange and the Chicago Board Options Exchange. The contracts are based on baskets of bonds, mostly U.S. Treasury securities. There are also options on GNMA securities and certificates of deposit.

Note of Caution: Because interest rates and bond prices move in opposite directions, using interest rate options requires a different thought process from trading in stock or index options. Interest-rate options should be avoided by most investors, particularly novice investors.

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Q. If I buy one OEX put option, what do I have?

A. If you buy one OEX put option, you have the right to sell the value of the basket of stocks at your strike price until the expiration date. It the value of the stocks included in the index declines, the value of your put contract will increase. If you buy an OEX put with a strike price of $325 and the index's value declines to $300, the value of your put should increase by about $2,500 ($25 times 100) less commissions.

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Q. If I buy one OEX call option, what do I have?

A. If you buy one OEX call option, you have the right to buy the value of the basket of stocks at your strike price until the expiration date. If you buy one OEX November 325 call and the value of the OEX index increases to $325, the value of a call on the index will increase to about $33,500 less commissions.

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Q. How do OEX contracts trade?

 A. Just like any option contract, OEX contracts are assigned expiration dates and strike prices based on the value of the index. If the value of the OEX index is $325, each contract will control $32,500 (100 times $325).

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Q. How can I determine the value of an OEX contract?

A. Financial tables giving the value of OEX contracts are published in most newspapers. Also, the updated values can be retrieved on the quote machines on brokers' desks.

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Q. What is the prospectus?

A. The prospectus contains a full description of option types and the risks involved in this type of investment. The prospectus is published by the OCC and must be made available to investor.

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Q. What is an option agreement?

A. An option agreement clarifies the investor's rights and obligations in option trading. Every investor must sign this agreement, affirming that he or she has read the agreement and is aware of the risks of option trading.

Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

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Q. What is an option disclosure statement?

A. An option disclosure statement is a document discussing the risks of trading options. It must be provided to an investor at or before the time at which the investor is approved for option trading.

You may review the Option Disclosure Statement by clicking on Characteristics and Risks of Standardized Options.

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For many years, investors could buy or sell options only on stocks traded on one of the exchanges. However, over the last few years, investors have become able to buy or sell options on a broad range of investments, such as stock market indexes, interest rates, US Treasury securities, and foreign

Source: Money & Investing Victor L. Harper., Arthur S. Brinkley., With Sarah E. Dale

 

 



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