What is an Option? A Detailed Look at Call and Put Options

Out of the Money vs. At the Money vs. In the Money

When an option holds intrinsic value, meaning the option holder would receive value by exercising the option and having the underlying security assigned to them, investors consider this option as “in the money.”

For example, a Call option qualifies as “in the money” if the price of the underlying asset is higher than the option contract strike price.  If a Call option has a strike price of $75 and the stock trades for $80, the option is in the money by $5.  

This same call option would be “out of the money” where these prices switched or “at the money” if equal.

Conversely, with Put options, the option is “in the money” when the underlying security price is lower than the option contract strike price, “out of the money” when reversed, and “at the money” with equal.

What Are Options Used For?

Depending upon the options owner’s strategy and the price of the underlying security, the options owner may make one of three decisions: 

  1. sell and close the options position 
  2. exercise the options contract and be assigned the underlying security
  3. let the options expire worthless

In the case of choice 1, if a secondary market in the options becomes unavailable, the options owner cannot engage in closing transactions and only has choices 2 and 3 available.  

For number 3, the options owner risks losing the entire investment in this case if, during the options contract period, the price of the underlying security deviates from the direction the options owner anticipated.  

In other words, the investor thought a price might rise and chose to purchase a call option but instead the stock nose-dived.

In this case, the options contracts lose all or a significant portion of their value, depending on where the market price lands in relation to the strike price.

To illustrate the above example, imagine someone has a bullish view on Google’s stock.  An options owner purchases a call option thinking the stock price will rise but the stock sinks instead.  

In this situation, the money spent to purchase the call option expires worthless, thereby losing the entire option contract investment.

Options help investors hedge risk, take speculative positions, or lock-in certainty.

Why Do Options Exist?

Markets crave certainty.  Options exist for the certainty they can provide in both price and expiration date but also as a hedging mechanism to safeguard a portfolio.  In other words, options can provide portfolio protection.  

When an investor hedges a portfolio, this reduces the risk in one security (or portfolio) by taking an offsetting position in a related security (or securities in the case of a portfolio). Many investors also consider alternative investment options to diversify their portfolio and hedge against market volatility.

Portfolio Protection: For example, put options exist for downside portfolio protection.  If an investor owns 100 shares of SPY, a S&P 500 exchange traded fund, and purchases $270 puts when the ETF trades above that level, the investor’s downside has a limit of $270.

Even if the S&P 500 dropped to 0, this investor would have the ability to sell 100 shares at $255.  On the other hand, if the put expires worthless, the only loss recognized is the premium paid for the put option.

Puts, when combined with portfolio assets, provide downside protection to a portfolio.

  • Downside Speculation: Conversely, puts allow an investor to speculate on downward movement in a security’s price.  If an investor feels a stock might decrease a put option allows the opportunity to take advantage of this expectation.

In this case, the investor need not own the underlying security to come out ahead.  Further examining the example above, were SPY to collapse from $270 (market and strike price) to $0 and the investor paid $20 for the put option, the total profit would come to $25,000 ($27,000 – $2,000 option premium).   

  • Asset Certainty: Options also exist because investors want to purchase assets with a certain price on or before a certain time while the same applies for those wishing to sell.
  • Market Clearing Function: These financial instruments facilitate asset transactions and provide a market clearing function whereby all trades can occur to terms under a standardized set of rules.
  • Highlight Market Expectations: Further, options prices change in line with real-time market prices and can also be useful for forecasting market expectations for a security’s future value.  Should you see an increase in option premiums across time in line with higher strike prices, the market expects this security to increase in value.

This leads to a discussion on the two factors determining the premium or value of an option.

How is an Option Valued?

An option’s value stems from two primary items and I shall use the example of a call option to illustrate:

  • Intrinsic Value. This represents the amount the holder stands to gain by exercising the option.  This amount is represented by the difference between the stock’s market price and the strike price for the option on the underlying security.  For example, if Google’s stock trades at $1,205 in the market and the strike price of a call option is $1,200, the $5 difference is the intrinsic value in the option premium.
  • Time Value. This relates to the time left on the option between now and the expiration.  This value represents the total option premium (amount paid for the option) minus the intrinsic value above.  In the Google example above, if the option premium paid was $15 and the intrinsic value was $5, then the time value would be $10 ($15 – $5).

As stated above, using these two value factors can show the market’s expectations for the security.

What is the Difference Between a Future and an Option?

Options are financial instruments giving an investor the right to purchase or sell an underlying security at an agreed strike price and expiration date.  A futures contract enforces this option by making both parties obligated to deliver the underlying asset for an agreed upon price.

This obligation difference separates an options contract from a futures contract.

The Value of Options

Options present the opportunity for a buyer and seller to measure the likelihood of an investment meeting their respective expectations.  To measure the success of this goal, options fall into one of three categories at expiration: 

  1. Out of the money (happy seller and unhappy buyer)
  2. At the money (buyer loses option premium while seller collects)
  3. In the money (happy buyer and unhappy seller)

The premium related to an option can have two components: the intrinsic value (how much the option is in the money), and the time value (difference between the intrinsic value and the premium).  

Generally speaking, the longer available time until expiration, the greater the time value.  As we discussed above, time value demonstrates the market’s expectations for how an underlying security will perform. 

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