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Call and Put Options

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Personal Tax
Stocks, Bonds etc. -> Call and Put Options

Call and Put Options

An option is a financial contract between two parties - the buyer (holder) and seller (writer).  The option gives the holder the right, and the writer the obligation, to buy or sell a predetermined amount of a certain stock (equity option) at a specified price (strike price), on or before a specified date (expiry date).

Options can be traded in things such as stocks, indexes, commodities and other financial instruments, but this article deals with equity and index options.

The holder of an option has a long position, while the writer of an option has a short position.

Options are traded in contracts, with each contract normally representing 100 shares of the underlying stock.

American-style options can be exercised by the holder at any time prior to expiry.  European-style options can only be exercised for a specified period of time prior to expiry.  According to the Chicago Board Options Exchange (CBOE), all equity options currently traded on US exchanges, and some index options, are American-style, while many index options are European-style.

Call option

A call is an option which gives
bullet the holder the right to buy a specified number of shares of a certain stock at the strike price on or before expiry date, and
bulletthe writer the obligation to sell the shares at the strike price, on or before expiry date, at the option of the holder.

Calls are purchased by those who expect the share price to be above the strike price at expiry date.  Calls are sold by those who expect the share price to be below the strike price at expiry date.

A call is in the money when the current market value of the stock is above the strike price.  It is out of the money when the current market value is below the strike price, and at the money when the two amounts are equal.

The writer of a call can choose to buy back the call on or before expiry date, if it has not yet been exercised by the holder.

The holder of a call can choose to sell the call on or before expiry date.

Covered vs. uncovered (naked) call

A call is covered when the writer of the call owns the underlying shares.  If the writer does not own the underlying shares, the call is uncovered.  Covered calls can be written in a registered account such as an RRSP, but uncovered calls cannot.

Put option

A put is an option which gives
bullet the holder  the right to sell a specified number of shares of a certain stock at the strike price on or before the expiry date, and
bulletthe writer the obligation to buy the shares at the strike price on or before the expiry date, at the option of the holder.

Puts are purchased by those who expect the share price to be below the strike price at expiry date.  Puts are sold by those who expect the share price to be above the strike price at expiry date.

A put option is in the money when the current market value of the stock is below the strike price.  It is out of the money when the current market value is above the strike price, and at the money when the two amounts are equal.

The writer of a put can choose to buy back the put on or before expiry date, if it has not yet been exercised by the holder.

The holder of a put can choose to sell the put on or before expiry date.

Covered vs. uncovered (naked) put

A put is covered if the writer of the put:

bullethas cash on deposit in an amount equal to the exercise value of the put, or
bullet has a short position in the underlying shares

Otherwise, the put is uncovered.

Learning about options

The Chicago Board Options Exchange (CBOE) is a good source for information on options.  They have online tutorials and courses, delayed quotes for stocks and options, and historical price information.  They also have downloadable quotes, which can be imported into a spreadsheet program.

Other articles:

bullet Tax Treatment of Income From Call and Put Options
bulletForeign Asset Reporting - T1135 Foreign Income Verification Statement

 

Revised: July 31, 2014

 

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