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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 (18)
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
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