An option is very simply explained as a choice to do or not do something.
As it relates to stocks, an option, on one side, is a choice to buy or sell a stock. One the other side, it’s an obligation to buy or sell a stock.
A few key terms and definitions you need to know before we get started.
Option contract: 1 contract represents 100 shares of a stock
Call option: choice/right to buy 100 shares of a stock
Put option: choice/right to sell 100 shares of a stock
Exercise: take action on the option
Assign: have action taken on the option
Strike Price: agreed upon price of action
Option Premium: upfront payment price made/received
Expiration: Once an option expires it is no longer able to be exercised or assigned
They are 4 different actions that are taken on each side for the buyer and the seller of the contract. We’re going to start with the basics. You can buy and sell options just like you buy and sell stock, with your broker.
Scenario 1: You buy one call option. You now own the option to buy 100 shares of the stock. If you want, you can buy (exercise your option) 100 shares of the stock at the agreed upon strike price.
Scenario 2: You sell one call option. You now are obligated to let someone else buy 100 shares of the stock. The person who bought the call option has that option to buy. If they decide to buy (you are assigned) then you are obligated to sell at the strike price.
Scenario 3: You buy one put option. You now own the option to sell 100 shares of the stock. If you want, you can exercise your option and sell at the agreed upon stock price.
Scenario 4: You sell one put option. You now are obligated to let someone else sell 100 of the stock. The person who bought the put option has that right to sell. If they decide to sell then you are obligated to buy 100 shares as they sell 100 shares.
Here’s a simple illustration on what would happen from your perspective
As you can see one trader gets the option and they can follow through or not, while the other trader is obligated to act. That is determined by who pays and who gets paid. The buyer of an option pays an option premium for the benefit of changing their mind. The seller of an option gets paid upfront so they have already received their benefit and they must follow through with the transaction.
Options on homes are somewhat similar, so I’ll finish with a story.
Nick, our financial success story for today, wants to buy the house that he’s renting right now, but he’s not sure if he will be able to move in because he’s up for a promotion and relocation at his job that does cad outsourcing. If he gets the promotion, he’ll have to move to Kansas. He’ll find out sometime in the next 3 months. He talks to his landlord and decides to keep renting but pays a $200 bucks for an option.
The landlord tells him that if he stays then he can turn the option into a mortgage and buy the house. They agree on the current market price of $300,000 because in 90 days the market price of the home could change. The landlord will be obligated to follow through with selling the house to Nick. If Nick does move, then the landlord gets to keep the money and Nick gets nothing. The option is good for 90 days but after 90 days Nick loses the option and the money he paid for it.
Nick is willing to pay for the peace of mind that the landlord won’t sell his house in the next 90 days while he’s renting it so the option has value to him.
I hope that story made it easier to understand the two sides of an option with a buyer and a seller.
Nick is like the buyer of a call option: he has the right to buy
The landlord is like the seller of a call option: he has the obligation to sell
The house is like the stock
The option premium is $200 dollars
The strike price is $300,000 dollars
Expiration is 90 days
We’ll go into the motivation behind why a trader would want to buy or sell and option in the next part of our options conversation. We will also talk about some pretty cool option strategy names like collar, butterfly, and iron condor. Until then check out some of the learning resources available at CBOE.com.
|Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.|
Update 2/24/2011: This post was included in the Stock Carnival Ecstasy hosted by FastSwings.
Photo Credits: http://www.skulpt.com/3d-animator-career-options.htm