An option is a contract to buy or sell a specific financial product known as the option's underlying instrument or underlying interest. (OIC)
A specific price at which the contract may be exercised or acted upon. (OIC)
A call is an option to buy. A put is an option to sell.
The date that an option and the right to exercise it cease to exist. (OIC)
In the case of cash settled options, the exercise receives the difference between the exercise price of the option being exercised and the exercise settlement value of the underlying instrument/index on the day the option is exercised. In the case of physically delivered options, the underlying entity is a physical good or commodity, like a common stock or a foreign currency. When its owner exercises that option, there is delivery of that physical good or commodity from one brokerage or trading account to another. (OIC)
European exercise is an option that can be exercised only during a specified period just prior to expiration. America exercise is an option that can be exercised any time prior to its expiration date. (OIC)
An option whose underlying interest is an index. Generally, index options are cash-settled. (OIC)
An option whose underlying interest is a futures contract. When the holder exercises an option on a future, he takes delivery of a futures position and not the underlying of the future.
An option’s premium has two main components: intrinsic value and time value.
Intrinsic Value. The intrinsic value of a call is the difference between the actual price and the exercise price. The intrinsic value of a put is the difference between the exercise price and the actual price.
Time Value. Time value is any premium in excess of intrinsic value before expiration. Time value is often explained as the amount an investor is willing to pay for an option above its intrinsic value. This amount reflects hope that the option’s value increases before expiration due to a favorable change in the underlying security’s price. The longer the amount of time available for market conditions to work to an investor's benefit, the greater the time value.
Major Factors Influencing Options Premium include underlying price, strike price, time till expiration, estimated future volatility, dividends or other income generated, cost of carry or interest rate,
Changes in the underlying security price can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase. However, the value of a put will generally decrease in price. A decrease in the underlying security's value generally has the opposite effect.
The strike price determines whether an option has intrinsic value. An in the money options has intrinsic value. An at the money option is all time value and is an option whose strike equals the underlying price. An out of the money has no intrinsic value, only time value. An option's premium (intrinsic value plus time value) generally increases as the option becomes further in-the-money. It decreases as the option becomes more deeply out-of-the-money.
Time until expiration affects the time value component of an option's premium. Generally, as expiration approaches, the levels of an option's time value decrease or erode for both puts and calls. This effect is most noticeable with at-the-money options.
Estimated future volatility can significantly affect the time value portion of an option's premium. Volatility is a measure of risk (uncertainty), or variability of price of an option's underlying security. Higher volatility estimates indicate greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike. It is most noticeable with at-the-money options.
The effect of an underlying security's dividends or other income and the current risk-free interest rate has a small but measurable effect on option premiums. This effect reflects the cost to carry shares in an underlying security. Cost of carry is the potential interest paid for margin or received from alternative investments (such as a Treasury bill) and the dividends from owning shares outright. Pricing takes into account an option’s hedged value so dividends from stock and interest paid or received for stock positions used to hedge options are a factor.
A calculated value of what estimated volatility is being used to calculate the option premium. It is calculated when the other values (strike price, underlying price, premium, time to expiration, dividends and interest rates are known.
Historical volatility is a measure of the actual standard deviation of price activity over a specified period of time. Sometimes historical volatility is used to calculate an options potential value as a proxy for estimated volatility; however, there is not necessarily a relationship between the past volatility of an option and the estimated future volatility of the underlying.
FLEX options are customizable products where the investor can set the terms for the tradable contract and have the security of an exchange-traded product. The exercise style, expiration date and strike price can all be chosen by the investor to create a new product that is not currently being traded at an exchange. In general, investors set the criteria and have their brokerage firm solicit the best possible market-price from different market participants. (OCC)
LEAPS stand for Long-Term Equity AnticiPation Securities® (LEAPS® ) issued by the Option Clearing Corporation (OCC) in the United States. Basically, LEAPS are options whose initial expiration period is longer than a year and up to 2 years, 8 months. Once an already issued LEAPS option has less than a year remaining to expiration, it becomes a regularly listed option. This may result in a symbol change.
Option Open Interest is the total number of outstanding option contracts on a given series or for a given underlying stock. The calculation is made on all options issued by the clearing house and is not broken down by where the option was first traded.
A measure of the rate of change in an option's theoretical value for a one-unit change in the price of the underlying stock. (OIC)
A measure of the rate of change in an option's Delta for a one-unit change in the price of the underlying stock. (OIC)
A measure of the rate of change in an option's theoretical value for a one-unit change in time to the option's expiration date. (OIC)
A measure of the rate of change in an option's theoretical value for a one-unit change in the volatility assumption. (OIC)
A measure of the expected change in an option's theoretical value for a 1% change in interest rates. (OIC)
The total value of an option’s premium is the value calculated by multiplying the quoted premium by the multiplier of the underlying, typically 100 shares for equity options.
For U.S. equity options, typically 100 shares, unless the option has been modified due to a corporate actions such as a merger or spinoff.
The owner (buyer) of an option must notify the clearing house before the option’s expiration that he intends to exercise the option and either buy or sell the underlying at the exercise price or receive a cash settlement for a cash settled option. The owner typically uses his clearing firm to send the instructions to the clearing house. In some cases, for options that are a certain percentage in the money, the option is exercised automatically.