Option Market Fundamentals

As stated in the Introduction to this book, a familiarity with option market fundamentals is the first of eight essentials that advanced option traders must master. This chapter reviews briefly the basic terminology of options and then explains the mechanics of margin accounts, short stock rebate, and calculation of the national best bid
and best offer (NBBO). Profit and loss diagrams of four basic strategies and eight intermediate and advanced strategies are presented with explanations.

A thorough understanding of the mechanics of these strategies is a necessary foundation for the discussions in later chapters.Fundamental Terms Options are contracts between buyers and sellers. Option buyers get a limited-time right to buy or sell some underlying instrument at a specific price.The seller of an option receives payment from the buyer and assumes the obligation to fulfill the terms of the contract if the buyer exercises the right.

A call option gives the buyer the right to buy the underlying instrument at the strike price until the expiration date. The seller of a call option is obligated to sell the underlying instrument at the strike price until the expiration date if the call buyer exercises the right to buy.A put option gives the buyer the right to sell the underlying instrument at the strike price until the expiration date.

The seller of a put is obligated to buy the underlying instrument at the strike price until the expiration date if the put buyer exercises the right to sell.The underlying instrument, or, simply, the underlying, can be a stock, a futures contract, a physical commodity, or a cash value based on some index. The strike price, or exercise price, is the specific price at which the underlying can be bought or sold, and the expiration date is the last day that an option can be exercised. After the expiration date, the option contract and the right cease to exist.

An option not exercised by the expiration date expires worthless.As an example, consider an “XYZ December 50 Call” that trades at a price of 3.00. The underlying is “XYZ,” which, in the United States, is typically 100 shares of XYZ stock. “December” indicates the expiration date, which, for stock options traded in the United States, is the third Friday of the stated month. The strike price of “50” is the price per share the buyer who exercises the call will pay for that XYZ stock.“3.00” represents the price per share of the option, so the purchaser of this option would pay $300 ($3 on 100 shares) to the seller.

Stock Trades Compared with Option Trades:Stock trades and option trades are similar in many ways, but option trades can be much more complicated transactions. The amount of information an option trader must convey to a broker is, by itself, significantly more than in a stock trade. To illustrate this difference, the upper section of Table 1-1 shows that a typical stock trade requires four pieces of information or decisions, and the lower section shows that a typical option trade requires seven pieces of information or decisions.

As indicated by the numbers, there are four parts to the stock trader’s instruction, “Buy long 1,500 XYZ at 63.50.” The first part of the instruction describes the action to take. In this example, “Buy long” is the action. For stock trades, there are four possible actions or types of trades.Buy long means that the stock is being newly purchased. Buy to cover means that a short stock position is being closed.

Sell long indicates that a trader wants to close a long stock position. Sell short indicates that a trader wants to create a new short stock position. In a short sale, the brokerage firm borrows shares on behalf of the trader and sells them in the market. The stock lender holds the cash proceeds from the sale. This type of action will be discussed in greater detail later in this chapter.The second part of the stock instruction represents the quantity to be bought or sold.

In this example, “1,500” is the quantity, or number,of shares being traded. The third part, “XYZ,” is the ticker symbol
of the stock being traded. Finally, the last part of the instruction,“at 63.50,” is the price per share at which the stock is to be purchased.Essentially, a stock trader has to decide which stock, the action or type of trade, how many shares, and at what price to trade them.

In the bottom portion of Table 1-1, the option instruction is “Buy to open 15 XYZ Jan 65 Calls at 2.80.” This instruction contains seven parts. As with stock trades, “Buy to open” describes the action. Also
similar to stock trades, option trades may consist of four possible actions. Buy to open indicates that a new long option position is being created. Buy to close means that an existing short option position is being closed.