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.
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Free eBook: The Rookie’s Guide to Options

I’ve made a free e-book available for download – and you don’t
have to register to receive a copy.

It’s an abbreviated version
of The Rookie’s Guide to Options and contains

  • Table of Contents

  • A brief excerpt
    from each chapter

  • An afterword

You may freely use this e-book. You can post it to your blog or website or
send a copy to anyone via e-mail.

Take this opportunity to get a glimpse into the world of options.

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Recommended Option Strategies

When I discuss option strategies on
this blog, the emphasis will be on making money and managing risk.

The following are the methods I
recommend for investors who already understand how options work.  For
rookies, I recommend the same strategies, but it's important not to begin
trading any of them without first gaining a good understanding of how each of
these strategies works and what you are trying to accomplish when you adopt
them.

  • Covered call writing
  • Cash-secured naked put selling
  • Collars
  • Credit and debit spreads
  • Iron condors
  • Diagonal, and double diagonal, spreads

As I continue to write this blog, I'll
offer tips on each strategy and reply to your questions.

For readers anxious to learn much more
about these methods more quickly, my newest book The Rookie's Guide to Options teaches you (in
detail) how to use each of these methods.

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Why You Should You Care About Options

If you want to learn about options and the advantages of using them
as part of your investment program, then this is your blog: Ask questions,
suggest topics for discussions, post comments.

Let me introduce myself. My name is Mark Wolfinger and I was a market
maker at the Chicago Board Options Exchange (CBOE) for 24 years, beginning in
1977. Over the past eight years, I’ve
been teaching individual investors how to use options conservatively to make
money and to reduce the risks
associated with investing in the stock market. I’ve also written
three books and numerous magazine
articles
.  You can
learn more about me
here.

I’ve learned a great deal of practical information about options
over the past 30 years, and the goal of this blog is to share some of that
information. I strongly believe that:

  • Investors who own stocks or
    mutual funds – people like you – can benefit by adopting conservative option
    strategies
  • Options were invented as
    risk-reducing investment tools, and not as toys for gamblers
  • It's easy to begin using options

p  Option strategies can be used
successfully by people who have little time to devote to their investments (but
those who have more time can achieve even better results)

Many of you may have heard that options are strictly for gamblers,
but that’s not true. If your stockbroker
feels that way, it’s time to change brokers. Sure, you can gamble with options, but I’ll try to convince you not to
do so.

I will not be offering any get-rich-quick gimmicks. I don’t guarantee profits, but if you adopt
one or more of the strategies I recommend on this blog, your chances of making
money are going to be better than if you simply buy and hold a stock (or mutual fund)
portfolio. 


If you are interested in
learning how options work, I’m here to help.

One rule: I won’t be making any stock market predictions or recommending
specific investments. Instead, I’ll help you understand options and how to use them effectively.  I’ll discuss different strategies and answer
your questions. 

Today, many professional traders, mutual funds, hedge funds, and individual
investors use stock options and trading
volume establishes new records year after year. Yet, there are vast numbers of
investors who remain unfamiliar with these versatile investment tools. If you are one of them, or even if you already understand a little about
options, this blog will provide useful information.

In future posts, I’ll write about stock volatility and why it’s so
important when trading options. If there
are other topics you want to see discussed in this blog, please post a comment
or question.

Returning to the title of today’s post, you should care about
options because they are useful investment tools that can help you achieve a
successful financial future.  As you
learn more about them, you can decide if options are appropriate for you.

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