Bruno Weber Maurer

Options: Introduction, Terminology &

Components
Bruno Weber Maurer

Abstract— This short paper will help you to understand more about options, its terminology, and its components. Understanding the terms
of an option contract and the rights and responsibilities around it is extremely important. Making it impossible to communicate or analyze
any desire of trading this security without this knowledge.

Index Terms— Options, Options Terminology, Options Components, Options contracts

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1 INTRODUCTION

O PTIONS contracts are a way to negotiate a separate pay-

ment to compensate someone for uncertainty. In effect,
the other part is offering to buy the right to decide later
option must make the final decision whether to buy, in the
case of a call, or to sell, in the case of a put. After expiration, all
rights and obligations under the option contract cease to exist.
whether to purchase an underlying asset. If there is an agree- On many stocks option exchanges, the expiration date for
ment on this separate payment, as well as the forward price, stock and stock index options is the third Friday of the expira-
they will enter an option contract. An option contract gives one tion month, in Brazil stock options expirate at the third Monday
party the right to decide later. In example, if someone is the of each month, if the market is closed at the day, then the expi-
buyer of a call option, this will give him the right to decide later ration date is moved to the next business day.
whether to buy. And the seller of the call option will have the To alleviate the problem of large order imbalances at expi-
obligation to do so. ration, some derivative exchanges, working with the stock
In this text we will focus primarily on stock options – one of exchanges on which the underlying stocks were traded,
the most common classes of exchange-traded options, along- agreed to establish an expiration value for a derivatives con-
side futures options. Although there is some trading in op- tract based on the opening price of the underlying contract
tions on physical commodities, bonds, and foreign currencies rather than the closing price on the last trading day. This AM
in OTC market, almost all exchange-traded options on these expiration is commonly used for stock index contracts. Options
instruments are futures options. A trader in exchange-traded on individual stocks are still subject to the tradition PM expira-
bond options is – really – trading options on bond futures. tion, where the value of an option is determined by the under-
lying stock price at the close of trading on the last trading day.
Although the expiration date for stock options is relatively
2 CONTRACT AND OPTION TERMINOLOGY
uniform, the expiration date for futures options can vary, de-
Every option market brings together traders and investors pending on the underlying commodity or financial instru-
with different expectations. Some intend to use options to pro- ment.
tect positions while others want to take advantage of price
discrepancies between similar or related products. Under- 2.3 Exercise Price
standing the terms of an option contract and the rights and The exercise or strike price is the price at which the under-
responsibilities under it is of utmost importance. Without this lying will be delivered should the holder of an option choose
understanding of language, a trader will find it impossible to to exercise his right to buy or sell. If the option is exercised, the
communicate his desire to buy or sell a contract – or, honestly, owner of a call will pay the exercise price; the owner of a put
know what he is doing. will receive the exercise price.
The exercise prices available for trading on an option ex-
2.1 Underlying change are usually set between equal intervals and bracketing
The underlying asset or, more simply, the underlying is the the current price of the underlying contract. If the price of the
security or commodity to be bought or sold under the terms of underlying contract is 62 when options are introduced, the
the option contract. If an option is bought directly from a deal- exchange may set exercise prices of 50, 55, 60, 65, 70, and 75.
er, the quantity of the underlying can be tailored to meet the At a later date, as the price moves up or down, the exchange
buyer’s individual requirement. If the option is burchased on can add additional exercise prices. If the price of the underly-
an exchange, the quantity of the underlying is set by the ex- ing rises to 70, the exchange may add exercise prices of 80, 85
change. On stock option exchanges, the underlying is typically and 90. Additionally, if the exchange feels that it will further
100 shares of stock. If, however, the price of an underlying facilitate trading, it can introduce intermediate exercise prices
stock is either very low or very high, an exchange may adjust – 52 ½, 57 ½, 62 ½, 67 ½.
the number of shares in the underlying contract in order to
create a contract size that is deemed reasonable for trading on 2.4 Exercise and Assignment
the exchange2.2 Expiration Date The buyer of a call or a put option has the right to exercise
The expiration date is the date on which the owner of an that option prior to its expiration date, thereby converting the
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option into a long underlying position in the case of a call or a futures and options on individual stocks tend to be American.
short underlying position in the case of a put. Once an option Options on indexes tend to be European.
is exercised, the rights and obligations associated with the op-
tion cease to exist, just as if the option had been allowed to
expire.
3 OPTION PRICE COMPONENTS
A trader who intends to exercise an option must submit an As in any competitive market, an option’s price, or pre-
exercise notice to either the seller of the option, if purchased mium, is determined by supply and demand. Buyers and
from a dealer, or to the exchange, if the option was purchased sellers make competitive bids and offers in the marketplace.
on an exchange. When a valid exercise notice is submitted, the When a bid and offer coincide, a trade is made.
seller of the option has been assigned. Depending on the type The premium paid for an option can be separated into two
of option, the seller will be required to take a long or short components – the intrinsic value and the time value. An option
position in the underlying contract at the option’s exercise has intrinsic value if it enables the holder of the option to buy
price. low and sell high or sell high and buy low, with the intrinsic
value being equal to the difference between the buying price
2.5 Settlement and the selling price. In example, an underlying contract trad-
Depending on the underlying contract, when an ex- ing at $435, the intrinsic value of a 400 call is $35. By exercising
change-traded option is exercised, it can settle into: the option, the holder of the 400 call can buy at $400. If he then
1. The physical underlying sells at the market price of $435, $35 will be credited to his ac-
2. Futures position count. With an underlying contract trading at $62, the intrinsic
3. Cash value of a 70 put is $8.
A call will only have intrinsic value if its exercise price is
Settlement into the Physical Underlying less than the current market price of the underlying contract
If a call option settles into the physical underlying, the ex- because no one would choose to buy high and sell low. A put
erciser pays the exercise price and in returns receives the un- will only have intrinsic value if its exercise price is greater
derlying. If a put option settles into the physical underlying, than the current market price of the underlying contract. The
the exerciser receives the exercise price and in return must amount of intrinsic value is the amount by which the exercise
deliver the underlying. Stock options always settle into the price is less than the current underlying price in the case of a
physical underlying. The profit or loss resulting from the op- call or the amount by which the exercise price is greater than
tion trade will depend on both the stock price and the price the current underlying price in the case of a put. No option
originally paid for the option. But the cash flow when the op- can have an intrinsic value less than zero and note that the
tion is exercised is independent of these. intrinsic value is independent of the expiration date.
Settlement into a Futures Position
Call intrinsic value = maximum of either 0 or S – X
If an option settles into a futures position, it is just as if the
Put intrinsic value = maximum of either 0 or X – S
exerciser is buying or selling the futures contract at the exer-
cise price. The position is immediately subject to futures-type
Usually, an option’s price in the marketplace will be greater
settlement, requiring a margin reposit and accompanied by a
than its intrinsic value. The time value, also referred to as the
variation payment.
option’s time premium or extrinsic value, is the additional
Settlement into Cash amount of premium beyond the intrinsic value that traders are
This type of settlement is used primarily for index con- willing to pay for an option. Market participants are willing to
tracts where delivery of the underlying contract is not practi- pay this additional amount primarily because of the protective
cal. If exercise of an option settles into cash, no underlying characteristics afforded by an option over an outright long or
position results. There is a cash payment equal to the differ- short position in the underlying contract.
ence between the exercise price and the underlying price at the An option’s premium is always composed of precisely its
ned of the trading day. intrinsic value and its time value. Example of intrinsic value
and time value is if a $400 call is trading at $50 with the under-
2.6 Exercise Style lying trading at $435, the time value of the call must be $15
In addition to the underlying contract, exercise price, expira- because the intrinsic value is $35. The two components must
tion date, and type, an option is further identified by its exer- add up to the option’s total premium of $50. If a $70 put on a
cise style, either Eropean or American. A European option can stock is trading for $11 with the stock trading at $62m the time
only be exercised at expiration. In practice, this means that the value of the put must be $3 because the intrinsic value is $8.
holder of a European option must take the final decision Again the intrinsic value and the time value must add up to
whether to exercise or not on the las tbusiness day prior to the option’s premium of $11.
expiration. In contrast, an American option can be exercised Even though an option’s premium is always composed of
on any business day prior to expiration. its intrinsic value and its time value, one or both of these com-
The designation of an option’s exercise style is either Euro- ponents can be zero. IF the option has no intrinsic value, its
pean or American has nothing to do with geographic location. prince in the marketplace will consist solely of time value. If
Many options traded in the US are European, and many op- the option has no time value, its price will consist solely of
tions traded in Europe are American. Generally, options on intrinsic value. In the latter case, traders say that the option is
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trading at parity.
Although an option’s intrinsic value can never be less than
zero, it is possible for a European option to have a negative
time value (more about this in the next chapters). When this
happens, the option can trade for less than parity. Usually,
however, an option’s premium will reflect some nonnegative
amount of time value.

REFERENCES
[1] Sheldon Natenberg, Option Volatility and Pricing: advanced trading strategies
and techniques – 2nd edition. McGraw Hill Education.

Options – 1st publication

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