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Options Education

Learn about investing in options

Understanding how options work

What is an option?

An option is a contract that gives the buyer the right (but not the obligation) to buy or sell an underlying asset at an agreed-upon price on or before an agreed-upon date.
Call options allow buyers to profit if the price of a stock or index increases, while put options allow the buyer to profit if the price of the stock or index declines. Investors can also short an option by selling them to other investors. In that case, shorting a call option would allow the seller to profit if the underlying price declines while selling a put option would allow the seller to profit if the price increases.

Why invest in options?

Options can be complex and are traded for a variety of reasons. Option traders can use options in multiple ways to carry out a speculative, hedging or income investment objective. In each example below we show some of the many ways that each of these strategies could be carried out.

Speculation

Traders can take both sides of the market, trading on both the upward or downward movement of a stock or index.
 Video 1 of 3
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Hedging their Investments

Investors can hedge their holdings by using options to protect against directional risk.
 Video 2 of 3
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Generating Income

Investors can sell options against shares they own, giving up upside gains in favor of generating income.
 Video 3 of 3
2:10

Things to consider

Options trading is not for everyone and it is important to understand the risks involved — especially since options are a decaying asset. There are varying degrees of risks involved with options that are dependent upon the strategy.
Although options may not be appropriate for all investors, they're among the most flexible of investment choices. Options can be used to apply a bullish, bearish or neutral strategy and utilized for generating income, hedging or speculation.

Options strategies

Here are 5 commonly used strategies. Log in to see additional strategies within the Options Strategy Assistant.

The Greeks

Often people refer to the Delta, Theta, Gamma, Vega and Rho of their options' positions. These are known as the Greeks. By better understanding the Greeks, investors can gain insight as to how an option's price may behave under a variety of conditions and external factors.
Delta
“How does the price of my options contract change if the price of the underlying stock or fund changes?”
Delta is the theoretical estimate of how much an option's value may change given a $1 move UP or DOWN in the underlying security. The Delta values range from −1 to +1, with 0 representing an option where the premium barely moves relative to price changes in the underlying stock.
The Delta value range of -1 to +1, with put strategies on the left in red and call strategies on the right in green. The Delta value range of -1 to +1, with put strategies on the left in red and call strategies on the right in green.
Delta helps us measure the sensitivity of an option to its underlying stock price.
A chart shows a call with a higher delta moves more than a call with a lower delta if the underlying stock price increases. A chart shows a call with a higher delta moves more than a call with a lower delta if the underlying stock price increases.
Theta
“How does the price of my option decay over time?”
Theta represents, in theory, how much an option's premium may decay each day with all other factors remaining the same.
A line chart shows Theta, with option value decreasing more quickly with time until it reaches $0 on the day of expiration. A line chart shows Theta, with option value decreasing more quickly with time until it reaches $0 on the day of expiration.

Buyer Beware

Since options are decaying in value, time favors the seller. The buyer needs extreme price movement to tip the scales.
A scale showing the buyer on the heavier side and the seller on the lighter side.
The Short Answer
Theta is an important Greek to understand — options are a decaying asset, and Theta measures that decay. Buying an option means time is working against you, slowly eating away the value of your option. Higher Theta is indicative of a higher rate of decay.
The Short Answer
Gamma can be used to measure the stability or the instability of Delta. A higher Gamma is an indication of a greater potential change in Delta which equates to an instability of Delta. Essentially, when utilizing Delta for the probability of being in-the-money at expiration, Gamma can help determine the stability of the probability Delta provides.
Vega
“How much does a change in implied volatility affect my options price?”
Vega measures the amount of increase or decrease in an option premium based on a 1% change in implied volatility. Implied volatility is defined as the market's forecast of a likely movement in the underlying security.
Vega and implied volatility can change without any movement from the underlying security.
A graph shows options with more days to expire will see a greater increase in Vega as the underlying nears the strike price. A graph shows options with more days to expire will see a greater increase in Vega as the underlying nears the strike price.
The Short Answer
Options tend to be more expensive when implied volatility is higher because of the increased range of potential movement. Thus, whenever implied volatility goes up, the price of the option goes up.
Rho
“How do interest rates affect the value of my options contract?”
Rho is a measure of an option's sensitivity to changes in the risk-free rate of interest (the interest paid on US Treasury Bills) and is expressed as the amount of money an option will lose or gain with a 1% change in interest rates.
Rho is positive for long calls (right to buy) and increases with the price of the stock. Rho is negative for long puts (right to sell) and approaches zero as the stock price increases. Rho is positive for short puts (obligation to buy), and negative for short calls (obligation to sell).
A graph shows Rho calls increase above $0 and Rho puts increase from a negative value towards $0 as stock price increases. A graph shows Rho calls increase above $0 and Rho puts increase from a negative value towards $0 as stock price increases.
The Short Answer
Interest rate risk has the greatest effect on longer dated options and is present mainly when holding cash in an interest bearing account is more advantageous. Mainly a concern for LEAPS® options (options with greater than 1 year until expiration).

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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.

The maximum loss, gain and breakeven of any options strategy only remains as defined so long as the strategy contains all original positions. Trading, rolling, assignment, or exercise of any portion of the strategy will result in a new maximum loss, gain and breakeven calculation, which will be materially different from the calculation when the strategy remains intact with all of the contemplated legs or positions. This is applicable to all options strategies inclusive of long options, short options and spreads. To learn more about Merrill's uncovered option handling practices, view Naked Option Stress Analysis (NOSA) (PDF).

Early assignment risk is always present for option writers (specific to American-style options only). Early assignment risk may be amplified in the event a call writer is short an option during the period the underlying security has an ex-dividend date. This is referred to as dividend risk.

Long options are exercised and short options are assigned. Note that American-style options can be assigned/exercised at any time through the day of expiration without prior notice. Options can be assigned/exercised after market close on expiration day. View specific Merrill Option Exercise & Assignment Practices (PDF).

Supporting documentation for any claims, comparison, recommendations, statistics, or other technical data, will be supplied upon request.
View definitions for investment terms in our Glossary.
When you purchase securities, you may pay for the securities in full, or if your account has been established as a margin account with the margin lending program, you may borrow part of the purchase price from Merrill. If you choose to borrow funds for your purchase, Merrill's collateral for the loan will be the securities purchased, other assets in your margin account, and your assets in any other accounts at Merrill. If the securities in your margin account decline in value, so does the value of the collateral supporting your loan, and, as a result, we can take action, such as to issue a margin call and/or sell securities in any of your accounts held with us, in order to maintain the required equity in your account. If your account has a Visa® card and/or checks, you may also create a margin debit if your withdrawals (by Visa card, checks, preauthorized debits, FTS or other transfers) exceed the sum of any available free credit balances plus available money account balances (such as bank deposit balances or money market funds). Please refer to your account documents for more information.

Before opening a margin account, you should carefully review the terms governing margin loans. For Individual Investor Accounts, these terms are contained in the Margin Lending Program Client Agreement. For all other accounts, the terms are in your account agreement and disclosures. It is important that you fully understand the risks involved in using margin. These risks include the following:
  • You can lose more funds than you deposit in the margin account. A decline in the value of securities that are bought on margin may require you to provide additional funds to us to avoid the forced sale of those securities or other securities in your account(s).
  • We can force the sale of securities in your account(s). If the equity in your account falls below the maintenance margin requirements or Merrill's higher "house" requirements, we can sell the securities in any of your accounts held by us to cover the margin deficiency. You also will be responsible for any shortfall in the account after such as sale.
  • We can sell your securities without contacting you. Some investors mistakenly believe that they must be contacted for a margin call to be valid, and that securities in their accounts cannot be liquidated to meet the call unless they are contacted first. This is not the case. We will attempt to notify you of margin calls, but we are not required to do so. Even if we have contacted you and provided a specific date by which you can meet a margin call, we can still take necessary steps to protect our financial interests, including immediately selling the securities without notice to you.
  • You are not entitled to choose which securities in your account(s) are liquidated or sold to meet a margin call. Because the securities are collateral for the margin loan, we have the right to decide which security to sell in order to protect our interests.
  • We can increase our "house" maintenance margin requirements at any time including on specific securities experiencing significant volatility and are not required to provide you advance written notice. These changes in our policy may take effect immediately and may result in the issuance of a maintenance margin call. Your failure to satisfy the call may cause us to liquidate or sell securities in your account(s).
  • You are not entitled to an extension of time on a margin call. While an extension of time to meet margin requirements may be available to you under certain conditions, you don't have a right to the extension.
If you have any questions or concerns about margin and the margin lending program, please contact the Merrill Investment Center at 855.332.5920.
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.
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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