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An option is a contract between a buyer and a seller. The option is connected to something, such as a listed stock, an exchange index, futures contracts, or real estate. For simplicity, this article will discuss only options connected to listed stocks.

Just to be complete, note that there are two basic types of options, the American and European. An American (or American-style) option is an option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American-Style. All stock options are American style. A European (or European-style) option is an option contract that can only be exercised on the expiration date. Futures contracts (i.e., options on commodities; see the article elsewhere in this FAQ) are generally European-style options. Every stock option is designated by: Name of the associated stock; Strike price; Expiration date. The premium paid for the option, plus brokers commission.

People also sell options without having owned them before. This is called "writing" options and explains (somewhat) the source of options, since neither the company (behind the stock that's behind the option) nor the options exchange issues options. If you have written a call (you are short a call), you have the obligation to sell shares at the strike price any time before the expiration date if you get called.

How do people trade these things? Options traders rarely exercise the option and buy (or sell) the underlying security. Instead, they buy back the option (if they originally wrote a put) or sell the option (if the originally bought a call). This saves commissions and all that. For example, you would buy a Feb 70 call today for $7 and, hopefully, sell it tommorow for $8, rather than actually calling the option (giving you the right to buy stock), buying the underlying stock, then turning around and selling the stock again. Paying commissions on those two stock trades gets expensive.

Although options offically expire on the Saturday immediately following the third Friday of the expiration month, for most mortals, that means the option expires the third Friday, since your friendly neighborhood broker or internet trading company won't talk to you on Saturday. The broker-broker settlements are done effective Saturday. Another way to look at the one day difference is this: unlike shares of stock which have a 3-day settlement interval, options settle the next day. In order to settle on the expiration date (Saturday), you have to exercise or trade the option by Friday. While most trades consider only weekdays as business days, the Saturday following the third Friday is a business day for expiring options.

The expiration of options contributes to the once-per-quarter "triple-witching day," the day on which three derivative instruments all expire on the same day. Stock index futures, stock index options and options on individual stocks all expire on this day, and because of this, trading volume is usually especially high on the stock exchanges that day. In 1987, the expiration of key index contracts was changed from the close of trading on that day to the open of trading on that day, which helped reduce the volatility of the markets somewhat by giving specialists more time to match orders.

You will frequently hear about both volume and open interest in reference to options (really any derivative contract). Volume is quite simply the number of contracts traded on a given day. The open interest is slightly more complicated. The open interest figure for a given option is the number of contracts outstanding at a given time. The open interest increases (you might say that an open interest is created) when trader A opens a new position by buying an option from trader B who did not previously hold a position in that option (B wrote the option, or in the lingo, was "short" the option). When trader A closes out the position by selling the option, the open interest either remain the same or go down. If A sells to someone who did not have a position before, or was already long, the open interest does not change. If A sells to someone who had a short position, the open interest decreases by one.

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