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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
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 The rain check has an expiration date, after which it is no longer valid.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- Expiration Date – the date, after which the option is no longer valid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.