What are Options?
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.
Still confused? The idea behind an option is present in many everyday situations. Say for example you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.
Now, consider two theoretical situations that might arise:
- It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1,000,000. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, your profit is $797,000 ($1,000,000 - $200,000 - $3,000).
- While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Unfortunately, you still lose the $3,000 price of the option.
This example demonstrates two very important points. First, when you buy an option, you have a right but not the obligation to do something. You can always let the expiration date go by, at which point the option is worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.
Calls and Puts
The two types of options are calls and puts:
A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.
Participants in the Options Market
There are four types of participants in options markets depending on the position they take:
- Buyers of calls
- Sellers of calls
- Buyers of puts
- Sellers of puts
People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.
Here is the important distinction between buyers and sellers:
- Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.
- Call writers and put writers (sellers) however may be obligated to buy or sell. This means that a seller may be required to make good on their promise to buy or sell.
Don't worry if this seems confusing–it is. For this reason we are going to look at options solely from the point of view of the buyer. Selling options is more complicated and can thus be even riskier. At this point it is sufficient to understand that there are two sides of an options contract.
The Lingo
To trade options, you'll have to know the terminology associated with the options market.
The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date, which is the third Friday of the specified expiration month. For example, a "June 60" call has a strike price of $60 and will expire on the third Friday in June.
An option that is traded on a national options exchange such as the CBOE is known as a listed option. These have fixed strike prices and expiration dates. Each listed option (known as a contract) represents 100 shares of company stock.
For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.
The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value), and volatility. Because of all these factors, determining the premium of an option is complicated and beyond the scope of this tutorial.