Options - Basics

To be, or not to be, that is the question
(Hamlet, Act III, Scene I)
 

What is an option:
An option is an contract between a buyer and a seller, which gives the buyer a right, but not an obligation, to trade (buy/sell) some asset at some point in future at a predecided price. In plain english terms, an option contract would say something like - "Ted (option buyer) can sell 100 IBM stocks (asset) at a price of $10/share on or before 15th July, to Fed". Let us assume that our hypothetical option comes for a price of $2.

Some terminology:
The asset on which the buyer of the option has a right to trade is called as the option underlying or underlier. 
The date till which the option is effective is called as the expiration date of the option.
The price at which the underlier gets traded is called as the option strike price.
Since an option contract gives the buyer a right but not an obligation, to trade the underlier, it has some cost associated with it. The buyer agrees to pay a one time amount called as option premium to the seller to buy the option.
So in our example above,
underlier => IBM stock
expiration date => 15th July
strike price => $10
premium => $2

Exercising an option:
When the buyer decided to use his right to trade the underlying security of the option that he owns, then this is called as exercising the option. In our example above, if on 13th July, Ted decided to sell 100 IBM stock shares to Fed at $10/share, then Ted is said to be exercising his option.

Types of option - put / call
When an option contract gives the buyer a right to buy the underlier at the strike price from the seller, on/before the expiration date, then it is called as a call option.
When an option contract gives the buyer a right to sell the underlier at the strike price to the seller, on/before the expiration date, then it is called as a put option.

Types of option - American / European / Bermudan
If the option can be exercised at any time on and before the expiration date, then it is called as an American option.
If the option can be exercised only at the expiration date, then it is called as an .European option.
If the option can be exercised only on a discrete set of days on and before the expiration date, then it is called as an Bermudan option. 

Buying and Selling puts and calls:
Buying a call option gives the buyer a right to buy the underlier at the strike price on/before the expiration date. 
Buying a put option gives the buyer a right to sell the underlier at the strike price on/before the expiration date.
Selling a call option obliges the seller to sell the underlier at the strike price on/before the expiration date, when (and if) the buyer wishes to exercise his option.
Selling a put option obliges the seller to buy the underlier at the strike price on/before the expiration date, when (and if) the buyer wishes to exercise his option.
Note that selling an option is more popularly known as writing an option.

in-the-money, out-of-money, at-the-money:
At the expiration date, if, for a -
call option, the current market price of the underlier is more than the strike price
OR
put option, the current market price of the underlier is less than the strike price
then, that option is said to be in-the-money. This is because it is offering the buyer of the option a more favourable price than the market price while exercising the option.

At the expiration date, if, for a -
call option, the current market price of the underlier is less than the strike price
OR
put option, the current market price of the underlier is more than the strike price
then, that option is said to be out-of-money. This is because it is offering the buyer of the option a less favourable price than the market price while exercising the option.

At the expiration date, if, for a -
call option, the current market price of the underlier is equal to the strike price
OR
put option, the current market price of the underlier is equal to the strike price
then, that option is said to be at-the-money. This is because it is offering the buyer of the option the same price as the market price while exercising the option.

As is obvious from above definitions, an option will be exercised only if it is in-the-money or at-the-money. When the option is out-of-money, the buyer of the option might as well chose to let the option expire and not exercise it since he is getting a better price in the market.

Some terminology:
Going Long: In the context of options, going long would mean to buy an option contract. So, the person who goes long on an option would have a right but no obligation to exercise the option. Further, his potential loss is limited by the amount of the premium paid.

Going Short: In the context of options, going short would mean to sell (write) an option contract. So, the person who goes short on an option would have an obligation to fullfill the assignment if the option holder decides to exercise the option. Further, his potential loss is theoritically unlimited (practically limited by the fact that stock price cannot go below zero).

Open a position: In the context of options, opening a position means to add to an existing set of positions already undertaken. One can open a new position by -

1. Going long i.e. opening a long position (buying an option contract).
2. Going short i.e. opening a short position (selling an option contract).

Close a position: In the context of options, closing a position means to reduce from an existing set of positions already undertaken. One can close an existing position by -

1. Going long i.e. Buying an option contract to offset an existing option contract that is written.
2. Going short i.e. Selling an option contract to offset an existing option contract that is bought.

With respect to options, a closing transaction is done to avoid actual delivery of the underlier. For e.g. a company may have strategically gone long on a call option to buy 100 cows. Now, they don't intend to actually exercise this option and take care of the cattle. Instead, they will simply close their transaction by going short on  a call option to sell away those 100 cows. Note that an option position can only be closed before the option holder exercises the option.

Exercising an option - Process flow

The diagram above depicts the typical participants involved in the process of exercising an option. When a client wants to exercise his option, he should inform his broker well before the expiration date. This broker will in turn inform the OCC (Options Clearing Corporation) of the intent of its client to exercise his option. The OCC would then pick up one clearing members from a pool of clearing members. Clearing members are nothing but brokers for short clients. The selected clearing member would have many clients who would have written an option contract with the same terms as the one the original client wants to exercise. The clearing member will pick up one such client randomly and then assign him the job of making the actual delivery.

Trivia: A short client may chose to close his position to avoid assignment as mentioned above. In case of stock options, a call option holder may chose to exercise the option well before the expiry since the company may be giving dividends and he  may want his share in the dividends. So, in such cases, the option writers should be alert as to the date of dividends so that they may close their positions well before that date.