What is an Option?
Every exchange-traded option is either a call option or a put option. The owner of a call option has the right to purchase the underlying good at a specific price, and this right lasts until a specific date. The owner of a put option has the right to sell the underlying good at a specific price, and this right lasts until a specific date. In short, the owner of a call option can call the underlying good away from someone else. Likewise, the owner of a put option can put the good to someone else by making the opposite party buy the good. To acquire these rights, owners of options buy them from other traders by paying the price, or premium, to a seller.
Options are created only by buying and selling. Therefore, for every owner of an option there is a seller. The seller of an option is also known as an option writer. The seller receives payment for an option from the purchaser. in exchange from payment received, the seller confers rights to the option owner. Ther seller of a call option receives payment and, in exchange, gives the owner of a call option the right to purchase the underlying good at a specific price with this right lasting for a specific time. The seller of a put option receives payment from the purchaser and promises to buy the underlying good at a specific price for a specific time, it the owner of the put option so chooses.
In these agreements, all rights lie with the owner of the option. in purchasing an option, the buyer makes payments and receives rights to buy or sell the underlying good on specific terms. In selling an option, the seller receiver payment and promises to sell or purchase the underlying good on specific temrs- at the discretion of the option owner. With put and call options the buyers and sellers, four basic positions are possible. Notice that the owner of an option has all the rights. After all, that is what the owner purchases. The seller of an option has all the obligations, because the seller undertakes obligations in exchange for payment.
Every option has an underlying good.The call writer gives the purchase the right to demand the underlying good from the writer. However, the writer of a call need not own the underlying good when he or she writes the option. If a seller writer a call and does not own the underlying good, the call is a naked call. If the writer owns the underlying good, he has sold a covered call. When a trader writes a naked call, he undertakes the obligation of immediately securing the underlying good and delivering it if the purchaser of the call chooses to exercise the call.
An option Example
Consider an option with a share of XYZ stock as the underlying good. Assume that today is March 1 and that XYX share trade at $110. The market, we assume, trades a call option to buy a share of XYZ at $100 with this right lasting until August 15 and the price of this option being $15. In this example, the owner of a call must pay $100 to acquire the stock. This $100 price is called the exercise price or the striking price. The price of the option, or the option premium, is $15. The option expires in 5.5 months, which gives 168 days until expiration.
If a trader buys the call option, he pays $15 and receives the right to purchase a share of XYZ stock by paying an additional $100, it he/she so chooses, by August 15. The seller of the option receives $15, and he/she promises to sell a share of XYZ for $100; if the owner of the call chooses to buy before August 15. Notice that the price of the option, the option premium, is paid when the option trades. The premium the seller receives is his/hers to keep whether or not the owner of the call decides to exercise the option. If the owner of the call exercises his option, he will pay $100 no matter what the current price of XYZ stock may be. If the owner of the option exercises his option, the seller of the option will receive the $100 exercise price when hi/she delivers the stock as he/she promised.
At the same time, puts will trade on XYZ. Consider a put with a striking price of $100 trading on March 1 that also expires on August 15. Assume that the price of the put is $5. If a trader purchases a put, he/she pays $5. In exchange, he/she receives the right to sell a share of XYZ for $100 at any time until August 15. The seller of the put receives $5, and he/she promises to buy the share of XYZ for $100 if the owner of the put option chooses to sell before August 15.
In both the put and call examples, the payment by the purchases is gone forever at the time the oprtion trades. The seller of the option receives the payment and keeps it, whatever the owner of the option decides to do. If the owner of the call exercises his/her option, then hi/she pays the exercise price as an additional amount and receives a share. Likewise, if the owner of the put exercises his.her option, then he/she surrenders the share and receives the exercise price as an additional amount. The owner of the option may choose never to exercise; in that case, the option will expire on August 15. The payment the seller receives is his/hers to keep whether or not the owner exercises. If the owner chooses not to exercise, the seller has a profit equal equal to premium received and does not have to perform under the terms of the option contract.
What is Moneyness?
"Moneyness" is an option concept that refers to the optential profit or loss from the immediate exercise of an option. An option may be in-the-money, out-of-the-money, or at-the-money.
A call option is in-the-money if the stock price exceeds the exercise price. e.g., a call option with an exercise-price of $100 on a stock trading at $110 is $10 in-the-money.
A call option is out-of-the-money if the stock price is less than the exercise price. e.g. if the stock is at $110 and the exercise price on a call is $115, the call is $5 out-of-the-money.
A call option is at-the-money if the stock price equals(or is very near to) the exercise price.
A put option is in-the-money if the stock price is below the exercise price. As an example, consider a put option with an exercise price of $70 on a stock that is worth $60. The put is $10 in-the-money, because the immediate exercise of the put would give $10 cash inflow. Similarly, if the put on the same stock had an exercise price of $55, the put would be $5 out-of-the-money. If the put had an exercise price equal to the stock price, the put would be at-the-money. Puts and calls can also be deep-in-the-money or deep-out-of-the-money, if the cash flows from an immediate exercise would be large in the speaker's judgment.
