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The purpose of this article is to help you navigate the incredibly complex world of options trading, and to understand what it means for an investment to “expire” or “go bad.”
All About Options
Options are a form of derivatives that allow investors to speculate on the price of a financial instrument – e.g., a stock, a bond, a commodity, or a basket of stocks and bonds – without actually owning the asset. The option buyer is typically a big, sophisticated company, while the option writer is typically a small, young startup or an individual investor.
There are three basic groups of options:
- Call options – These allow the buyer to require the option holder to buy or sell an underlying asset at a certain price by a certain date. Calls are typically more expensive than puts, but have the advantage of being binary in nature (i.e., either you buy the stock or you don’t).
- Put options – These allow the buyer to require the option holder to sell an underlying asset at a certain price by a certain date. Puts are typically less expensive than calls, but have the disadvantage of being uni-directional (i.e., you either sell the asset or you don’t).
- Expiration options – These allow the buyer to require the option holder to sell the underlying asset at a certain price by a certain date, or for the option to expire worthless (i.e., the buyer is not required to buy the asset at the expiration date). Expired puts and calls typically lose their value, although many exchanges and brokers will honor them as a price that the underlying asset had at the time of expiration. Expired options are usually the hardest to value, as there’s not always an easy way of knowing what the asset will be worth at the expiration date. If you’re trying to evaluate the true cost of ownership of a particular investment based on its options, then you should probably just walk away.
What Is the Expiration Date?
The expiration date of an option is the date by which the option must be settled. Options that expire without being exercised are considered to be “in the money,” while options that are exercised prior to the expiration date are considered to be “out of the money.” The date of expiration can be a few days, weeks, or months after the trade date.
What Is the Strike Price?
The strike price for an option is the price at which the underlying asset is agreed to be traded. Stated another way, the strike price is the price the buyer is willing to pay for the option. When an option is issued, the strike price is usually the last price paid for the underlying asset minus the premium paid to secure the option. Stated yet another way, the strike price is the price the buyer is willing to pay, in addition to the premium, to make the option worth exercising.
What Is the Purpose Of The Premium?
When an option is issued, the buyer must pay a premium to the option seller to secure the right to enter into the option contract. The premium is usually expressed as a percentage of the price of the underlying asset or as a fixed amount of money. For example, a $100 call option on a stock that is trading at $100 per share would cost the buyer $100 (i.e., the fixed premium) in addition to the $100 they’re spending on the call option. In this case, the strike price is $100 per share, so the option would be “in the money” for the buyer once the stock price hits $100 per share.
More About Options
Options can be used for a variety of investment purposes. They’re usually priced to give investors the chance to make a profit off the difference in value between the strike price and the price of the underlying asset at the time the option expires. As we’ve discussed, options that expire without being exercised are typically the most profitable. Unfortunately, options that expire without being exercised can also become quite dangerous, as they never really go away and can wreak havoc on an investor’s finances if they’re not cared for properly. Options that are out of the money at expiration have the potential to lose value, or even disappear, so careful consideration should always be given as to whether or not to exercise them.
Should I Exercise or Should I Let Expiration Ruin My Fun?
When it comes to options, too often investors and traders think in terms of whether or not to “exercise,” instead of what they should be thinking about – whether or not to “sell” their positions before the expiration date. The answer is often found in the context of the overall portfolio and the money manager’s investment policies. Letting options expire without being sold can result in large losses for options traders who did not have strict investment policies in place. In general, it’s preferable to exercise options and then sell them at the appropriate time, rather than letting them expire and potentially causing you to lose money on the position.
As an investor, if you find yourself in a position where you’re worried about whether or not to exercise an option, then there’s a good chance you’re already in too deep. It may be time to cut your losses and walk away.