Options – Advisory From The Securities Exchange Commission

from the Securities and Exchange Commission

The SEC’s Office of Investor Education is issuing this investor bulletin to help educate investors about the basics, including some of the potential risks, of options trading. Options trading may occur in a variety of securities marketplaces and may involve a wide range of financial products, from stocks to foreign currencies. This bulletin focuses on the basics of trading listed stock options.

What are Options?

• Options are contracts giving the owner the right to buy or sell an underlying asset, at a fixed price, on or before a specified future date.
• Options are derivatives (they derive their value from their underlying assets). The underlying assets can include, among other things, stocks, stock indexes, exchange traded funds, fixed income products, foreign currencies, or commodities.
• Option contracts trade in various securities marketplaces between a variety of market participants, including institutional investors, professional traders, and individual investors.
• Options trades can be for a single contract or for several contracts.

Basic Options Terminology

Options trading uses terminology that an investor should understand before attempting to buy or sell options. The following example of a basic stock option contract quote will help explain some of this terminology:

“ABC December 70 Call $2.20”

This options quote contains five terms: “ABC,” “December,” “70,” “Call,” and “$2.20.”

“ABC” – This represents the stock symbol for the underlying stock of the option contract.

“December” – This is the expiration date of the option contract. This date indicates the day that the option contract expires. Generally, the expiration date for an option contract is the Saturday after the third Friday of each month. However, certain option contracts may have an expiration date that occurs after only a week, a calendar quarter, or at other some other specified time. Investors should make sure they understand when an option contract expires since an option contract’s value is directly related to its expiration date. If you need help determining an option contract’s expiration date, ask your brokerage firm.

“Call” and “Put” – A call is a type of option contract. Two of the most common types of option contracts are callsand puts. A call option is a contract that gives the buyer the right to buy shares of an underlying stock at the strike price (discussed below) for a specified period of time. Conversely, the seller of the call option is obligated to sell those shares to the buyer of the call option who exercises his or her option to buy on or before the expiration date.

Example: An ABC December 70 Call entitles the buyer to purchase shares of ABC common stock at $70 per share at any time prior to option’s expiration date in December.

A put option is a contract that gives the buyer the right to sell shares of an underlying stock at the strike price for a specified period of time. Conversely, the seller of the put option is obligated to buy those shares from the buyer of the put option who exercises his or her option to sell on or before the expiration date.

Example: An ABC December 70 Put entitles the buyer to sell shares of ABC common stock at $70 per share at any time prior to option’s expiration date in December.

“70” – The number appearing in this part of the options quote is the strike price of the option contract. This is the price at which the buyer of the option contract may buy the underlying stock, if the option contract is a call, or sell the underlying stock, if the option contract is a put. The relationship between the strike price and the actual price of a stock determines whether the option is “in-the-money,” “at-the-money,” or “out of the money.”

“In-the-money” and “out-of-the money” have different meanings depending on whether the option is a call or a put:

• A call option is in-the-money if the strike price is below the actual stock price;
• A put option is in-the-money if the strike price is above the actual stock price.

Example (in-the-money call option): An investor purchases an ABC December 70 Call and ABC’s current stock price is $80. The buyer’s option position is in-the-money by $10, since the option gives the buyer the right to purchase ABC stock for $70.

• A call option is out-of-the-money if the strike price is above the actual stock price;
• A put option is out-of-the-money if the strike price is below the actual stock price.

Example (out-of-the-money call option): An investor purchases an ABC December 70 Call and ABC’s current stock price is $60. The buyer’s option position is out-of-the-money by $10, since the option gives the buyer the right to purchase ABC stock for $70.

“At-the-money” has the same meaning for puts and calls and indicates that the strike price and the actual price are the same.

“$2.20” – The number appearing in this part of the options quote is the premium or the price per share you pay to purchase the option contract. An option contract generally represents 100 shares of the underlying stock. In this case, a premium of $2.20 represents a payment of $220 per option contract ($2.20 x 100 shares). The premium is paid up front to the seller of the option contract and is non-refundable. The amount of the premium is determined by several factors including: (i) the underlying stock price in relation to the strike price, (ii) the length of time until the option contract expires, and (iii) the price volatility of the underlying stock.

In addition to the terms above, investors should also be familiar with the following options terminology:

Exercise – When a buyer invokes his or her right to buy or sell the underlying security it’s called “exercising” the right.

Assignment – When a buyer exercises his or her right under an option contract, the seller of the option contract receives a notice called an assignment notifying the seller that he or she must fulfill the obligation to buy or sell the underlying stock at the strike price.

Holder and Writer – A buyer of an options contract can also be referred to as a “holder” of that options contract. A seller of an options contract can also be referred to as the “writer” of that options contract.

Options Trading

Market Participants – There are generally four types of market participants in options trading: (1) buyer of calls; (2) sellers of calls; (3) buyers of puts; and (4) sellers of puts.

Opening a Position – When you buy or write a new options contract, you are establishing an open position. That means that you have established one side of an options contract and will be matched with a buyer or seller on the other side of the contract.

Closing a Position – If you already hold an options contract or have written one, but want to get out of the contract, you can close your position, which means either selling the same option you bought (if you are a holder), or buying the same option contract you sold (if you are a writer).

Now that we have discussed some of the basics of options trading, the following are examples of basic call and put option transactions:

Call Option: On December 1, 2014, ABC Stock is trading at $68 per share. You believe the price of ABC stock will rise soon and decide to purchase an ABC December 70 Call. The premium is $2.20 for the ABC December 70 Call. The expiration date of the option is the third Friday of December and the strike price is $70. The total price of the contract is $2.20 x 100 = $220 (plus commissions which we will not account for in this example).

• Since the strike price of the call option is $70, the stock must rise above $70 before the call option is “in-the-money.” Additionally, since the contract premium is $2.20 per share, the price of ABC would need to rise to $72.20 in order for you to break even on the transaction.

• Two weeks later the stock price has risen to $80. As the value of the underlying stock has increased, the premium on the ABC December 70 Call has also increased to $10.20, making the option contract now worth $10.20 x 100 = $1020. If you sell the option now (closing your position) you would collect the difference between the premium you paid and the current premium $1020-$220 = $800 (minus any commission costs). Alternatively, you could exercise the option and buy the underlying shares from the writer of the call for $70 (the strike price); the writer is obligated to sell the buyer those shares at $70 even though their market value is $80.

• Now, suppose you believe the price of the stock will continue rising until the expiration date and you decide to wait to sell or exercise the option. Unfortunately, the stock price drops to $65 on the expiration date. Since this is less than the $70 strike price, the option is out-of-the-money and expires worthless. This means you will have lost the initial $220 premium you paid for the options contract.

Put Option: On December 1, 2014, ABC Stock is trading at $72 per share. You believe the price of ABC stock will fall soon and decide to purchase an ABC December 70 Put. The premium is $2.20 for the ABC December 70 Put. The expiration date of the option is the third Friday of December and the strike price is $70. The total price of the contract is $2.20 x 100 = $220 (plus commissions which we will not account for in this example).

• Since the strike price of the put option is $70, the stock must drop below $70 before the put option is “in-the-money.” Additionally, since the contract premium is $2.20 per share, the price of ABC would need to drop to $67.80 in order for you to break even on the transaction.

• Two weeks later the stock price has dropped to $60. As the value of the underlying stock has decreased, the premium on the ABC December 70 Put has increased to $10.20, making the option contract now worth $10.20 x 100 = $1020. If you sell the option now (closing your position) you would collect the difference between the premium you paid and the current premium $1020-$220 = $800 (minus any commission costs). Alternatively, you could exercise the option and sell the underlying shares to the writer of the put for $70 (the strike price); the writer is obligated to buy those shares at $70 even though their market value is $60.

• Now, suppose you believe the price of the stock will continue dropping up until the expiration date and you decide to wait to sell or exercise the option. Unfortunately, the stock price rises to $75 on the expiration date. Since this is more than the $70 strike price, the option is out-of-the-money and expires worthless. This means you will have lost the initial $220 premium you paid for the options contract.

These two examples provide you with a basic idea of how options transactions may operate. Investors should note that these examples are some of the most basic forms of options. Many options contracts and the trading strategies that utilize them are much more complex. The Additional Resources section below provides a hyperlink to additional publications you may review if you are interested in information on more complex options contracts and trading strategies.

What are some of the risks associated with trading options?

Options like other securities carry no guarantees, and investors should be aware that it is possible to lose all of your initial investment, and sometimes more. For example:

Option holders risk the entire amount of the premium paid to purchase the option. If a holder’s option expires “out-of-the-money” the entire premium will be lost.

Option writers may carry an even higher level of risk since certain types of options contracts can expose writers tounlimited potential losses.

Other risks associated with trading options include:

Market Risk – Extreme market volatility near an expiration date could cause price changes that result in the option expiring worthless.

Underlying Asset Risk – Since options derive their value from an underlying asset, which may be a stock or securities index, any risk factors that impact the price of the underlying asset will also indirectly impact the price and value of the option.

For additional information on the risks associated with trading options please read Chapter X of the Options Clearing Council’s publication “Characteristics and Risks of Standardized Options” located at http://www.optionsclearing.com/about/publications/character-risks.jsp.

Opening an Options Account

The SEC’s Office of Investor Education is issuing this investor bulletin to help you to understand what to expect when opening an options trading account with your broker-dealer.

Before you can trade options, your broker must approve your brokerage account for options trading. In order to be approved for options trading, you will need to fill out your broker’s options agreement. In an options agreement, you will need to provide information that will assist your broker in determining your knowledge of options and trading strategies, as well as your general investing knowledge and your financial ability to bear the risks of options trading. Based on the information you provide, your broker will determine whether options trading is suitable for you and, if so, what types of options trading may occur in your account.

Information You Will Need to Provide

The information you will need to provide in an options agreement generally includes, among other things:

• Investment objectives such as capital preservation, income, growth, or speculation;
• Trading experience such as the number of years you have been trading stocks and/or options, the number of trades you make per year, the average size of each trade, and information about your general knowledge of investing;
• Personal financial information such as liquid net worth (investments easily sold for cash), total net worth, annual income, and employment information; and
• An indication of what types of options you would like to trade.

Trading Levels

The information you provide in your options agreement allows your brokerage firm to determine which option trading levels, if any, you qualify for in your account. These trading levels determine the types of option trades you can execute in your account. Broker-dealers generally offer 5 levels of option trading representing varying degrees of risk. Level 1 generally represents the lowest level of risk, while level 5 generally represents the highest level of risk. The types of option trading that occurs at each level and even the number of levels may vary among brokerage firms. You may ask your brokerage firm to provide you with a list and description of each option trading level it has available for its customers.

Apart from the options agreement, SEC and FINRA rules require brokers to provide certain disclosures to all potential options investors. For example, your broker must provide you with a copy of a publication from the Options Clearing Corporation called “Characteristics and Risks of Standardized Options.” This publication contains basic information about the characteristics of options as well as detailed examples about the risks associated with various options and options trading strategies. Make sure you read this publication and carefully consider the information in it before you begin trading options. For additional information on some of the basics of options trading, you may also review the SEC’s investor bulletin “An Introduction to Options” located at http://investor.gov/news-alerts/investor-bulletins/investor-bulletin-introduction-options.

Additional Resources

This bulletin provides a general overview of the steps an investor must take to open an options trading account with his or her broker-dealer. For more specific details on how to open an options trading account, investors should contact their broker-dealer. For additional information on options and the options marketplace, investors should consider reviewing the following:

Options Clearing Council’s publication “Characteristics and Risks of Standardized Options” located at http://www.optionsclearing.com/about/publications/character-risks.jsp.

The Chicago Board of Options Exchange Education Center located at http://www.cboe.com/learncenter/

The NASDAQ Options Trading Guide located at http://www.nasdaq.com/investing/options-guide/