What Is an Option?

I love trading options. My goal is to interest you in using options to make your investing more enjoyable, more profitable, and less risky.

I’m not trying to sell newsletter subscriptions or encourage you to buy costly software. This blog is for options education and discussion. If want to know more about me, look here.

Please participate by posting questions and comments or send e-mail, and together we’ll build a blog where option rookies gain enough information to trade confidently and profitably. Remember, I offer no get-rich-quick schemes. I believe in education – and that means I want to encourage visitors to understand how options work before investing their money. Rookies can open a paper-trading account with a broker and temporarily trade options without using real money.

Let’s get started.

The options world has its own vocabulary – something I refer to as Optionspeak. When I mention a word or phrase whose definition may not be clear to you, I’ll highlight the word and include a definition below. Here’s a more complete
glossary.

An option is a contract between two people:  a buyer and a seller. The price the buyer pays to the seller is called the premium.
 
When an investor buys an option, he pays the premium, and in return, accumulates some rights. Those rights are temporary and expire on a date specified in the contract.

 

When an investor sells an option, she collects the premium, and in return, accepts some temporary obligations.

There are two types of options: Calls and Puts

A call option gives its owner the right to buy 100 shares of a specific stock (called the underlying
asset
) at a specific price (called the strike price) for a limited time (until the expiration date).

A put option gives its owner the right to sell 100 shares of a specific stock at a specific price for a limited time.

If an option owner elects to buy (sell) those shares, the option owner is said to exercise the option. More on this topic soon.

That's all there is to it.  Options are easy to understand – and you have been using them for years.  Did you ever go to a store to buy a sale item, only to discover that the item was out of stock?  Did you get a rain check from the customer service department?  If yes, then you are familiar with options, because the rain check is a call option.

That rain check gives you the right to come back to the store to buy that sale item (underlying asset) at the sale price (strike price). The rain check has an expiration date, after which it is no longer valid.  The supermarket gave you that rain check at no cost. Thus, you “bought” the option by paying a premium of zero.

Consider an automobile insurance policy.  When you pay the premium to buy collision insurance, you are buying the right to sell your car (underlying asset) to the insurance company for the strike price (the amount for which the car is insured) if it's “totaled” in an accident – as long as the accident occurs before the expiration date. Thus, the insurance policy is similar to a put option (there are subtle differences).

When we use options in the stock market, the underlying asset is 100 shares of stock. 

Today’s optionspeak terms:

  • Expiration Date – the date, after which the option is no longer valid
  • Underlying asset – the item that the option owner can buy or sell
  • Strike price – the price at which the underlying asset can be bought or sold
  • Premium – the price paid for the put or call option
  • Call Option – a contract that gives its owner the right to buy the underlying
    at the strike price
  • Put option – a contract that gives its owner the right to sell the underlying
    at the strike price
  • Exercise – The act by which an option owner does what the contract
    allows. The call owner exercises the
    call and buys 100 shares of stock, paying the strike rice for each share. By exercising a put option, the investor
    sells 100 shares at the strike price.
4

One Response to What Is an Option?

  1. Don 06/16/2008 at 10:07 PM #

    Regarding credit spreads, if one is in the money on a current position, and no light is at the end of the tunnel, is there a rolling technique for credit spreads or is it best to close it and open a new spread with enough credit to cover the loss?