A Definition of Option Contracts Along WIth Some Common Characteristics
n. An agreement between a buyer and a seller where the buyer pays for the option to either buy stock at a specified price or sell stock at a specified price.
I like to keep my options open. I’m known for changing my mind. (Doug Liman)
Related Terms
- Call Option: Grants the buyer the right to purchase shares of stock at a specified price within a specific time period
- Put Option: Grants the buyer the right to sell shares of stock at a specified price within a specific time period
- Option Seller: The party writing the option contract.
- Option Holder: The option buyer, the one paying the Option Seller.
- Short option: An option that has been sold (or written).
- Long option: An option that has been purchased.
- ITM: In the Money
- OOTM: Out of the Money
- DTE: Days to Expiration
- Leap: A long dated option (typically more than six months)
- Extrinsic Value: A portion of the price of the option contract that is associated with factors other than stock price such as time and volatility. Deep ITM options have very little extrinsic value.
- Intrinsic Value: A portion of the price of the option contract associated with the underlying stock price. OOTM options have no intrinsic value.
Key Facts
- There are two types of options: Calls and Puts. Calls rise in price as the stock goes up and Puts do the opposite.
- Stocks don’t have an expiration date, options do. That makes them difficult to manage as one has to be correct in terms of both direction and timing.
- Options were originally created to help investors manage their stock positions during certain periods of unknowns.
Why option contracts?
Options were originally invented for investors to hedge their stock positions. For example if an investor owned shares of a company, say Coca-Cola (KO), for many years and they thought that the stock price would dip in the near term, then instead of selling shares, they could use options to protect a portion of their holdings and in this manner avoid some of the repercussions associated with selling shares which might include increased taxes, loss of dividends and loss of potential upside in case the investor is wrong.
Leverage
The other reason for options is to give investors the ability to leverage their portfolios. Options provide tremendous leverage for short periods of time. For example instead of buying 100 shares of a stock, an investor can buy a call option for a fraction of the price. Of course, if the investor doesn’t get the move that they want then the option may expire worthless at expiration.
Timing is everything
When you dollar cost average into a stock position, your time horizon is potentially infinite. There’s no expiration on stock. Which means that if you’re wrong in the near term, you can always wait for the stock to move the way you thought it would. Not true with option contracts. With options you need to be right in terms of direction and time. If you’re not then you simply lose the amount paid for the option contract.
Option Strategies
Since the invention of options, investors have been combining them in creative ways that we call option strategies. It’s ok if you haven’t heard of a Jade Lizard. Option strategies will have a number of legs to account for the different options that make up the strategy.
For example, a single leg option strategy is to buy or sell a call or put option. A two legged option strategy might be a Vertical Spread or Calendar Spread where one option is sold as the first leg and another option is purchased as a second leg.
Legging in and out
The legs of the option strategy could be executed at the same time or in different orders. If in different orders, then the investor is said to “leg into” or “leg out” of the option position. For example if I wanted to sell a Vertical Put Spread on a particular stock, then I could simultaneously sell and buy the two options, or I might buy an option first and only after the stock moves sell the other leg.
Our Take
We prefer to sell option contracts than to buy them. We prefer to sell option contracts in order to scale into and out of stock positions. This is how our options trading bot will operate the Wheel Strategy.