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.
56 Comments
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
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