What are Options?

Definition: An option contract is an agreement between two parties to buy/sell an asset (stock or futures contract as an example) at a fixed price and fixed date in the future.

It is called an option because the buyer is not obliged to carry out the transaction. If, over the life of the contract, the asset value decreases, the buyer can simply elect not to exercise his/her right to buy/sell the asset.

There are two types of option contracts - Call options and Put options. A Call option gives the buyer the right to buy the underlying asset, while a Put option gives the buyer the right to sell the underlying asset.

A simple example: Peter buys a Call option contract from Sarah. The contract states that Peter will buy 100 Microsoft shares from Sarah on the 5th May for $25. The current share price for Microsoft is $30.

Note: this is an example of a Call option as it gives Peter the right to buy the underlying asset.

If the share price of Microsoft is trading above $25 on the 5th May, then Peter will exercise the option and Sarah will have to sell him Microsoft shares for $25. With Microsoft trading anywhere above $25 Peter can make an instant profit by taking the shares from Sarah at the agreed price of $25 and then selling the shares on the open market for whatever the current share price is and making a profit.

The $25 value, which is stated in the agreement, is referred to as the Exercise (or Strike) Price. This is the price at which the asset will be exchanged.

The date (in this case 5th May) is known as the Expiry (or Maturity) Date. This date is the deadline for the option contract. At this date, the option buyer is to decide if a transaction of the underlying asset is to occur.

Outcomes: Let's imagine that at the expiration date, Microsoft is trading at $30, then Peter will buy the shares from Sarah at the agreed $25 and then he can sell them back on the open market for $30 and make an instant $5.

Alternatively, if Microsoft is trading at $20, then buying the shares from Sarah at $25 is too expensive as he can buy them on the open market for $20 and save $5. In this situation, Peter would choose not to exercise his right to buy the shares and let the options contract expire worthless. His only loss would be the amount that he paid to Sarah when he bought the contract, which is called the Option Premium - more on that a little later. Sarah would, however, keep the option premium received from Peter as her profit.

In the real world of exchange traded options, transactions don't really take place between two people like I've explained above. The process of Novation actually removes the identity of who is on the other side of the trade. You simply Buy or Sell an option contract from the exchange without knowing who is on the other side.

Comments (53)

Vinod

August 20th, 2012 at 1:17am

Thanks . you describe all in very simple words.simple to understand.Great.
Thanks very much.

utut

June 28th, 2012 at 12:00pm

Thank you so much for such a simple and easy explanation

V S Dager

May 12th, 2012 at 6:23am

Really u taught in very simple way.Thnx.
But I hv to learn more.
Is it all on your site ?
Thanx again.

Raj

April 20th, 2012 at 5:43am

thanks a lot. wll explained..

Radhika

April 17th, 2012 at 6:41am

First time understood it clearly.Thanks a ton. I wish i had come across this site before

Peter

April 1st, 2012 at 9:17pm

Hi Gordon,

Yep, I've heard of binary trading platforms - although I don't have any experience in trading in them.

As I understand it, you buy either a call or a put depending on your view of the market at a certain price: the strike price. If the market is above (below) the strike at the expiration date you receive a fixed payout agreed at the trade date.

Gordon

March 31st, 2012 at 2:36pm

Have you ever heard of binary trade options? As I understand its following trends to decide whether to call or put on an item. Is this a valid strategy?

Peter

March 26th, 2012 at 7:45pm

Thanks Nitin!

Sam Jordan

March 22nd, 2012 at 6:15pm

It is really easy to understand :)
Thanks a lot

Nitin

March 17th, 2012 at 6:57am

First article I read on options, which did not confuse me even for few milliseconds!.

geet

March 6th, 2012 at 7:15am

completely understood.....awesome explanation.

AVN RAJA

February 13th, 2012 at 6:22am

Thank you really it is informative for me.

Lokesh Agarwal

February 10th, 2012 at 12:34pm

wonderful.. thx a lot mate.. for making me understand what is option contract

Kunal Moon

January 31st, 2012 at 1:02pm

nicely explained

Peter

January 11th, 2012 at 10:18pm

Hi Scarlett, no it is novation - it is also mentioned on Wikipedia under Application in financial markets.

Scarlett

January 11th, 2012 at 4:42am

"The process of Novation actually removes the identity of who is on the other side of the trade." Peter, do you mean notation instead of novation? Cheers.

pooja

December 19th, 2011 at 2:18am

very simple language
easy to understand
thanks

Muhammad Jami

October 24th, 2011 at 2:05am

You are doing a great service explaining these complex instruments. Thank you very much.

sureshsinh

October 6th, 2011 at 11:55am

Awesome

J

May 12th, 2011 at 10:48am

very informative and explanatory. Thank you.

Joemike

April 29th, 2011 at 8:27pm

I am trying to begin option trading soon.

I thought your explanation is very clear.

jan

February 14th, 2011 at 9:30am

ssn is social security number. or they ask for your IRS number which i have not of course as i am not an american. I have found one site named option alarm that offered a free trial. but so far i cannot follow their advice as it is very confusing what they say. i have to learn that languague first. do you have some others? thanks a lot.

Peter

February 10th, 2011 at 4:06am

What's an SSN?

Yep, I do look at those sites. You're best off taking advantage of any free trials that they offer. Do you have any ones in mind...I can take a look if you like?

jan

February 10th, 2011 at 1:19am

thank you i have been looking for such site long time as I am from Slovakia and many sites require SSN for example. now I have to find out if I can sign up there. one more question. what do you think about those web sites where they advise you with options picks? r u using them sometimes?

Peter

February 9th, 2011 at 3:48pm

Hi Jan, yep I trade real options through Interactive Brokers. Yes, if you are short a put option and are exercised then you will be assigned a real stock position.

jan

February 9th, 2011 at 3:18pm

peter, are you trading thorough your broker real options? for example if you go short put and the option is exercised, do you actually buy that stock and own it in your account? or is it just derivate?

preeti

February 7th, 2011 at 3:30am

very clear and informative

Swapnil

January 7th, 2011 at 4:54am

the description given is constructive and clear to understand

Peter

November 18th, 2010 at 10:58pm

Hi Narayan, sure, could you be more specific with your question?

narayan

November 17th, 2010 at 8:04pm

Hi thanks for upload. I just want to know the relationship between the option and risk management. Could anyone can tell me more about that?

Shaniyas

October 21st, 2010 at 4:52am

Itz so clear nd informative. Really appreciate ur way f clarifying d things.

cnu

October 20th, 2010 at 8:00am

Good explanation

Dr. Sayyed AbdulKarim

September 23rd, 2010 at 10:13am

Excellent. So simple n yet so informative.
Pl.keep it up.
sayyedsr@gmail.com

Gary

September 14th, 2010 at 9:17pm

A professor once explained; too many instructors or those who hold knowledge you seek tend to make simple things complex. by taking something complex or simple and making it simple is the key to an excellent teacher. You have truly succeeded. Thank you!

Archana

September 13th, 2010 at 5:13am

Very Clear.. Really appreciate it.. Thank you very much..

chandu

August 8th, 2010 at 7:57am

nice and easy to understand

Vishal Hemrajani

July 28th, 2010 at 9:16am

Good explanation

Rocks

June 11th, 2010 at 7:49am

Zuperbbbb.. simple & effective

Avishek

May 14th, 2010 at 2:43am

you done a great job....it realy helpful for me.....thanks.

Steven

January 2nd, 2010 at 9:03pm

Good explanation with examples can get here...

nic

September 29th, 2009 at 7:13pm

great site i am fom wales and read rich dad books which has created my interest in options to make money ast and with little risk AFTER my financial education , so i reckon 80 hours of reading your excellent material and then i will start very small trading options

newbie

September 11th, 2009 at 8:58am

i truly appreciate wot u've done. made it so comprehensive. thank u thank u thank u

Milanthi

June 2nd, 2009 at 11:18pm

This is so amazing, I have gone through several sites to understand what really options mean, but non of the meanings were clear to me, but this site information is so clear.

Peter

May 12th, 2009 at 6:34am

Hi Glen,

What broker do you use? I use Interactive Brokers and their application doesn't require that you actually know the symbol of each option...you enter the underlying stock code and then request the "option chain", which then populates the trading page with all of the options for that asset.

If your broker does require that you enter the actual symbol, you could try looking it up at either finance.yahoo.com or cboe.com. Or find another broker ;-)

Glen O'Riordan

May 9th, 2009 at 4:45am

I'd like to trade options, specifically to buy call options. My online broker offers the categories buy to open, buy to close, sell to open, and sell to close. I've figured out that I need to buy to open, but am unable to control what position I want to open, presumably due to ignorance. When asked for the symbol, do I enter the stock symbol or some special option symbol, and if there is a special symbol for the option, how can I find it?

naidu

April 29th, 2009 at 8:05am

very useful info for a novice.

behzad

January 27th, 2009 at 10:14am

thank you,
helpfull,short and clear

Admin

January 2nd, 2009 at 6:52am

You can buy a put option any time...no need to already own a call.

You're never obliged to purchase the asset. That's why they're called options as you have the "right" but not the "obligation".

Chris

December 30th, 2008 at 5:14pm

So what if the Call option is trading for less than $25 then your still obliged to purchase the option

johnson

December 30th, 2008 at 11:28am

so you can not buy put option if you haven't had already call option?

HH

December 2nd, 2008 at 2:31pm

To the point. Thanks for clarifying.

ansar

November 30th, 2008 at 2:27pm

simple to understand a very difficult concept
thank you very much for making it easy for us

Brajesh

November 26th, 2008 at 11:53am

Nice and informative definition to start with

Add a Comment

Name

Enter Verification Image

Comments

     Subscribe for Comment Updates