To understand how options work, one needs first to understand what an option is.A call gives the owner of the option the right to buy the underlying security.As in any transaction, there are two parties to an option contract—a buyer and a seller.Contractual Rights and Obligations:The option buyer is the party who owns the right inherent in the contract. The buyer is referred to as having a long position and may also be called the holder,or owner, of the option. The right doesn’t last forever. At some point the option will expire.
At expiration, the owner may exercise the right or, if the option has no value to the holder, let it expire without exercising it. But he need not hold the option until expiration. Options are transferable—they can be traded intraday in much the same way as stock is traded. Because it’s uncertain what the underlying stock price of the option will be at expiration,much of the time this right has value before it expires.
The uncertainty of stock prices, after all, is the raison d’eˆtre of the option market.A long position in an option contract, however, is fundamentally different from a long position in a stock. Owning corporate stock affords the shareholder ownership rights, which may include the right to vote in corporate affairs and the right to receive dividends. Owning an option represents strictly the right either to buy the stock or to sell it, depending on whether it’s a call or a put.
Option holders do not receive dividends that would be paid to the shareholders of the underlying stock, nor do they have voting rights. The corporation has no knowledge of the parties to the option contract. The contract is created by the buyer and seller of the option and made available by being listed on an exchange.The party to the contract who is referred to as the option seller, also called the option writer, has a short position in the option.
Instead of having a right to take a position in the underlying stock, as the buyer does, the seller incurs an obligation to potentially either buy or sell the stock. When a trader who is long an option exercises, a trader with a short position gets assigned.Assignment means the trader with the short option position is called on to fulfill the obligation that was established when the contract was sold.
Shorting an option is fundamentally different from shorting a stock.Corporations have a quantifiable number of outstanding shares available for trading, which must be borrowed to create a short position, but establishing a short position in an option does not require borrowing; the contract is simply created. The strategy of shorting stock is implemented statistically far less frequently than simply buying stock, but that is not at all the case with options.
For every open long-option contract, there is an open short-option contract—they are equally common.Opening and Closing:Traders’ option orders are either opening or closing transactions. When traders with no position in a particular option buy the option, they buy to open. If, in the future, the traders wish to eliminate the position by selling the option they own, the traders enter a sell to close order—they are closing the position.
Likewise, if traders with no position in a particular option want to sell an option, thereby creating a short position, the traders execute a sell-to-open transaction. When the traders cover the short position by buying back the option, the traders enter a buy-to-close order.Open Interest and Volume:Traders use many types of market data to make trading decisions. Two items that are often studied but sometimes misunderstood are volume and open interest.
Volume, as the name implies, is the total number of contracts traded during a time period. Often, volume is stated on a one-day basis, but could be stated per week, month, year, or otherwise. Once a new period (day) begins, volume begins again at zero. Open interest is the number of contracts that have been created and remain outstanding.
Open interest is a running total.When an option is first listed, there are no open contracts. If Trader A opens a long position in a newly listed option by buying a one-lot, or one contract, from Trader B, who by selling is also opening a position, a contract is created. One contract traded, so the volume is one. Since both parties opened a position and one contract was created, the open interest in thisparticular option is one contract as well.