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Leverage & Risk

Options involve risk and are not suitable for all investors.
Options involve risk and are not suitable for all investors. Certain requirements must be met to trade options. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved in investing with options. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options (PDF)" before considering any option transaction. You may also call the Investment Center at 877.653.4732 for a copy. A separate client agreement is needed. Multi-leg option orders are charged one base commission per order, plus a per-contract charge.
Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying product.
Select to close help pop-up A short call option in which the seller (writer) does not own the shares of underlying stock represented by his or her options contracts or an offsetting long call options contract. If assigned, the seller is obligated to deliver the underlying security at the strike price. As the writer does not own the underlying security, the writer may have to purchase the underlying security at any price in order to meet the obligation. This represents unlimited risk as the underlying security has unlimited upward potential.
Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage could magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered call optionHover to view help pop-upSelect to view help pop-upA short call option in which the seller (writer) does not own the shares of underlying stock represented by his or her options contracts or an offsetting long call options contract. If assigned, the seller is obligated to deliver the underlying security at the strike price. As the writer does not own the underlying security, the writer may have to purchase the underlying security at any price in order to meet the obligation. This represents unlimited risk as the underlying security has unlimited upward potential. writer may face unlimited risk.

In-the-money, At-the-money, Out-of-the-money

An option's strike price, or exercise price, determines whether a contract is in-the-money, at-the-money, or out-of-the-money. This price is then compared to the current market price of the underlying to determine if the contract is more favorable (in-the-money), the same value as (at-the-money), or not favorable (out-of-the-money) than the current market price.
If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money. This is because the holder of this call has the right to buy the stock at a price less than the price he would pay to buy the stock in the stock market. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is said to be in-the-money because the holder of this put has the right to sell the stock at a price greater than the price he would receive selling the stock in the stock market.
The inverse of in-the-money is out-of-the-money. If the strike price equals the current market price, the option is said to be at-the-money.
The amount that an option, call or put is in-the-money at any time is called intrinsic value. By definition, an at-the-money or out-of-the-money option has no intrinsic value. This does not mean investors can obtain these options at no cost.
The amount that an option's total premium exceeds intrinsic value is known as the time value. Fluctuations in volatility, interest rates, dividend amounts and the passage of time all affect the time value portion of an option's premium. These factors give options value and therefore affect the premium at which they are traded.

Time Decay

The longer the time remaining until an option's expiration, the higher its premium will be. This is because the longer an option's lifetime, the greater the possibility that the underlying share price might move the option in-the-money. Even if all other factors affecting an option's price remain the same, the time value portion of an option's premium will decrease (or decay) with the passage of time.

Note:

Time decay is a term used to describe how the theoretical value of an option reduces with the passage of time. Time decay increases rapidly in the last several weeks of an option's life. When an option expires in-the-money, it is generally worth only its intrinsic value as there is no time left in the contract.

Expiration Day

The expiration date is the last day an option exists. For listed stock options, this is usually on the third Friday of the month. This is the deadline that brokerage firms must submit exercise or do not exercise notices to the Options Clearing Corp (OCC). However, the exchanges and brokerage firms have regulations and deadlines for an option holder to notify the brokerage firm of his intent to exercise. This deadline, or expiration cut off time, is generally the third Friday of the month at some time after the close of the market.
The last day expiring equity options trade is also on the third Friday of the month. If that Friday is an exchange holiday, the last trading day will be one day earlier.

Long

With respect to this section's usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account.
For example, if you have purchased the right to buy 100 shares of a stock and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock and are holding that right in your brokerage account, you are long a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account or elsewhere, you are long 1,000 shares of stock.
When you are long an equity option contract:
  • You have the right to exercise that option at any time prior to expiration.
  • Your potential loss is limited to the amount you paid for the option contract.

Short

With respect to this section's usage of the word, short describes a position in options in which you have written a contract (sold a contract that you did not own). As a result, you now have obligations from terms of that option contract. If the owner exercises the option, you must meet those obligations.
If you have sold the right to buy 100 shares of a stock, you are short a call contract. If you have sold the right to sell 100 shares of a stock, you are short a put contract.
When you write an option contract, you are creating it. The writer of an option collects and keeps the premium received from its initial sale. When you are short (write) an equity option contract:
  • You can be assigned an exercise notice at any time during the life of the option contract. You should be aware that assignment prior to expiration is a distinct possibility.
  • Your potential loss on a short call is theoretically unlimited. For a put, the fact that the stock cannot fall below $0 in price limits the risk of loss. This potential loss could still be quite large if the underlying stock declines significantly in price.

Open

An opening transaction is one that adds to or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, consider both:
  • Buy to open: An opening purchase is a transaction in which the purchaser's intention is to create or increase a long position in a given series of options.
  • Sell to open: An opening sale is a transaction in which the seller's intention is to create or increase a short position in a given series of options.

Close

  • Buy to close: A closing purchase is a transaction in which the purchaser's intent is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as covering a short position.
  • Sell to close: A closing sale is a transaction in which the seller's intent is to reduce or eliminate a long position in a given series of options.

Note:

An investor does not close out a long call position by purchasing a put or vice versa. A closing transaction for an option involves the purchase or sale of an option contract with the same terms on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option's last trading day.
Content licensed from the Options Industry Council is intended to educate investors about U.S. exchange-listed options issued by The Options Clearing Corporation, and shall not be construed as furnishing investment advice or being a recommendation, solicitation or offer to buy or sell any option or any other security. Options involve risk and are not suitable for all investors.

Content licensed from the Options Industry Council. All Rights Reserved. OIC or its affiliates shall not be responsible for content contained on Merrill's Website, or other Company Materials not provided by OIC. OIC education can be accessed at the OIC web site popup.
Select to close help pop-up A short call option in which the seller (writer) does not own the shares of underlying stock represented by his or her options contracts or an offsetting long call options contract. If assigned, the seller is obligated to deliver the underlying security at the strike price. As the writer does not own the underlying security, the writer may have to purchase the underlying security at any price in order to meet the obligation. This represents unlimited risk as the underlying security has unlimited upward potential.

Without the Jargon

Purchasing an option that represents 100 shares of a stock is generally less expensive than actually purchasing the 100 shares of stock – this is how options provide leverage. However, options can have higher risks than stocks and can have unlimited loss potential. (Uncovered call optionsHover to view help pop-upSelect to view help pop-upA short call option in which the seller (writer) does not own the shares of underlying stock represented by his or her options contracts or an offsetting long call options contract. If assigned, the seller is obligated to deliver the underlying security at the strike price. As the writer does not own the underlying security, the writer may have to purchase the underlying security at any price in order to meet the obligation. This represents unlimited risk as the underlying security has unlimited upward potential. can result in an unlimited loss). Unlike stocks, options have a set amount of terms which include an expiration date. Theoretically, you can hold a stock forever (assuming it does not become bankrupt or acquired) whereas an option will only trade for a set period of time and then will cease to exist.
Information not provided by the Options Industry Council
Options involve risk and are not suitable for all investors. Certain requirements must be met to trade options. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved in investing with options. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options (PDF)" before considering any option transaction. You may also call the Investment Center at 877.653.4732 for a copy. A separate client agreement is needed. Multi-leg option orders are charged one base commission per order, plus a per-contract charge.
View definitions for investment terms in our Glossary.
The material was provided by a third party not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.
For purposes of all the computations discussed in this article, commissions, fees and margin interest and taxes, have not been included in the examples. These costs obviously will impact the outcome of any stock or option transaction. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Past performance is not a guarantee of future results.
This material is being provided for informational purposes only. Nothing herein is or should be construed as investment, legal or tax advice, a recommendation of any kind, a solicitation of clients, or an offer to sell or a solicitation of an offer to invest in options. The information herein has been obtained from third-party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed.

Supporting documentation for any claims, comparisons, recommendations, statistics or other technical data will be furnished on request.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
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Investing in securities involves risks, and there is always the potential of losing money when you invest in securities.

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