How Stock Options Work

The following example illustrates how options contracts work. Investor A thinks that the Exxon Corporation stock will increase, but does not want to invest great amounts of money that is needed to buy 100 shares. Investor A can buy a call option contract for 100 shares of the Exxon Corporation with a strike price (or exercise price) of $35 per share. Investor N signed this contract to sell 100 shares from Exxon Corporation stock at a strike price of $35 per share. In that same period the Exxon stock was being negotiated at around $38 per share. Both investors have different points of view about what is going to happen with prices of Exxon?s shares.

Investor A thinks that prices will increase while investor N foresees that share prices will fall in a near future.

Investor N takes the risk of loss in case Exxon stock prices raise instead of falling. If Investor A exercises the option to call in the stock then Investor N will have to buy Exxon?s stocks at a higher price and give it to Investor A.

Investor N is compensated for this risk by collecting from the buyer of the contract an amount of money called Premium or Option Price. If Premium is $3 per share , Investor A will pay $300 to Investor N for the call option contract buy giving Investor A the right to buy 100 shares from Exxon stock at $35 per share before the contract?s expiration date if Exxon?s stock prices raise above $35 per share within a specified period of time before expiration date, Investor A will benefit if carries on the option.

Let?s pretend Exxon stock goes up $42 per share within a reasonable period of time, and Investor A decides to carry out the option. Under call option terms Investor A has the right to buy 100 shares of Exxon?s stocks at $35 per share. Investor A pays Investor N the amount of $3500 for 100 Exxon shares. If Investor N does not own those 100 Exxon shares he will have to buy stocks at $4200 (100 shares at $42 per share) and transfer them to Investor A.

Investor A paid a total amount of $3800 : $300 for the option (Premium price) plus $3500 for the stock. Costs for Investor N ended up in $400 total loss, detailed as follows: an outlay of $4200 that was partially offset by Investors A $3500 receipt per stock plus $300 for the option contract. If on the other hand the Exxon stock price falls to $32 and keeps the price during the whole contract period, Investor A will have lost the Premium contract amount ($300). That is because the most an investor can loose when buying an option is the value of the option contract.

The advantage of a call option is that the investor has a high degree of leverage (a small amount of money $3 per share that controls a larger sum, $35 per share). The option buyer also has to benefit by selling the option if there is no increase in Premium price. Also, Investor N has some alternatives. If Investor N wants to get rid of the contract it may buy someone else?s contract.

Option?s negotiation is lightened up greatly because of the Options Clearing Corporation (OCC) who besides maintaining a liquid market place, it also keeps track of options and positions of each investor. Option buyers and writers do not negotiate directly but through the Option?s Cleariang Corporation. When an investor buys a contract the OCC acts as a broker and makes sure that contract provisions be followed. When the contract is carried out, the OCC guarantees that the option buyer receives his stocks even when the writer incurs in default on delivery.

Equally, the OCC helps buyer and writer in the process of closing out their position. When the buyer of an option contract wants to sell the contract, the OCC will cancel both entries in account of the investors. That same process is followed with writer  a contract. If the writer wants out of its position, it will buy the contract which then offsets the original position.

A smart reader will immediately notice that in order for the OCC to guarantee these processes, there would have to be standardized contracts. Generally, they are launched into the market at the same time as the option in a stock, having identical terms except the strike (exercise) price. The contract period for stock options is standardized with three, six and nine months expiration dates. They have been introduced in the options exchange with longer terms called Long-term Equity Anticipation Securities (LEAPS).

LEAPS can have a 3 year life span before expiring. They have similar characteristics to the short-term option contracts but as they have a longer period to expiration they have higher Premium prices.

Reading Option Quotes
Newspapers do not list every available stock option because  of the great number of contracts in the market. But they do print the list of the most negotiated stock options. Consequently if you do not find a particular stock option on the newspapers listings, it does not mean that these have expired. Probably, it was not an actively  negotiated option at that day.

Different web sites in the internet provide a more complete list of options, as well as information related to their negotiation.