Buying and Selling an Option

We’ll now leave the real estate analogy, and deal with stocks, the actual underlying asset for options. In the world of options trading, the underlying would be a single stock (an equity option), or a group of stocks represented by one symbol (an index option). An example of the latter would be the Dow Jones Industrials, represented by the symbol DIA.

When someone purchases a call option, they are buying the right to purchase a stock (or index) for a specific strike price, within a period of time. The available strikes are typically relative to the price of the underlying. In general, overall strike prices available for equity options start at 5, and increment by 2 ½ up to approximately 50. They then increment by 5 up to 100, where they begin incrementing by 10. Index options have strikes that typically increment by 1 or 2.

There are three terms used to classify the price of an option in relation to the price of the stock:
1. At the money (ATM): the price of the underlying is (relatively) equal to the strike
2. In the money (ITM): for calls, the strike is below price of the underlying. For puts, the strike is above the price of the underlying
3. Out of the money (OTM): for calls, the strike is above the price of the underlying. For puts, the strike is below the price of the underlying

Options have a date by which they must be exercised. For a given month, the expiration is the Saturday after the third Friday. For example, the June 2007 options will expire on June 16. However, option holders must notify their brokerage of their intent to exercise by the previous trading day, since the exchanges are closed on Saturdays. The available months for expiration are typically the current month, the following month, and then future months, based on one of three cycles:
· January, April, July, October
· February, May, August, November
· March, June, September, December
(Note: The “current month” actually changes to the following month once expiration Friday has passed. The subsequent months also change accordingly. For example, the current month would be August up until the Saturday after 3rd Friday in August. Then, the “current month” would be September, even though there would still be days remaining in August.) There are also longer-term options, which we discuss in the LEAPS section.

Each option contract (Call or Put) represents 100 shares of the underlying. Therefore, when observing the price of a contract, we must multiply by 100 to obtain the true price for entering an agreement.

For example, let’s say we are examining the XYZ stock. It is currently trading at $35 per share, and the date is currently early December. If we were to obtain the option chain, which lists the available options, we would likely see strike prices ranging from ranging from approximately 5 to 55, depending on the volatility of the stock. (Note: all prices would be available, but many data sources only show the strikes near the trading value of the stock.) They would likely increment in value by 2.5 from 5 to 50 (i.e. 5, 7.5, 10, 12.5, etc). They would then increment by 5.

We would also see expiration months of December, January, April, and July. Once the Saturday after the 3rd Friday passed, we would see expiration months of January, February, May, and August.

Let’s imagine we wish to buy the January 40 Call, which costs $2. This call is considered out of the money (OTM), because the strike is above the current price of the stock. This would allow us to purchase XYZ for $40 per share, any time between now and the 3rd Friday in January. It would cost us $200 ($2 X 100) to buy one contract, since each represents 100 shares. If we chose to exercise the contract, we’d have to pay $4,000 ($40 X 100).