Cost of the Contract
When you buy an option, the cost of that option is called a premium. Since you're opening the position by making a purchase, you start at a net debit. If the option expires worthless, you won't recover the premium you paid for the contract. And, if you either exercise or sell the contract, you must subtract the cost of the premium from your return to calculate your net profit or loss. Commissions and other trading costs also apply on each transaction.
For example, if you buy a put on NRQ stock for $200 with a strike price of $53, and the stock's price reaches $51 a share, you can exercise the option and sell the shares at the strike price. Here, you would receive $5,300 from the sale ($53 per share x 100 shares per contract). To figure your net profit, first take the proceeds from this transaction, or $5,100 ($5,300 - $200 premium) and subtract the money you paid for the shares when you bought them initially. For example, if you originally purchased the shares at $49, an investment of $4,900 ($49 per share x 100 shares), your true net profit would actually be $200 ($5,100 - $4,900).
If you sell a contract, you receive the premium and start out at a net credit. If the option expires, the premium becomes your profit and the buyer's loss. If the option is exercised, you still keep the premium, but are obligated to buy or sell the underlying from the buyer.
For instance, if you sell a put with a premium of $200, the $200 is yours to keep, even if you have to pay $5,300 for the underlying shares if the contract is exercised. In this case, your net cost on the transaction would be $5,100.
Contract prices are not fixed, but fluctuate based on a number of factors: the price of the underlying; strike price; dividends; timed expiration; volatility; and interest rates. As a result, the premium you pay today will likely be higher or lower than the premium another investor paid yesterday or will pay tomorrow.
Examples exclude transaction costs and tax considerations.
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available at your local Scottrade branch office or from the Options Clearing Corporation at 1-888-OPTIONS or by visiting www.888options.com). All option accounts require prior approval by Scottrade. Market volatility, volume, and system availability may impact account access and trade execution. Supporting documentation for any claims will be supplied upon request.