What Is An Option?

An option is a contract that derives its value from an underlying asset – a stock, forex currency pair, commodity, etc. That contract either gives the owner the right to buy the asset - CALL option - or the right to sell the asset - PUT option - at a predetermined price and within some predetermined time frame. The predetermined price is called the STRIKE price. The predetermined time frame is the month of the option contract.

The key idea here is that the owner of an option has a right, but not an obligation. If the owner of the option does not exercise this right before the predetermined time, then the option and the opportunity to exercise it will cease to exist and the option the option will expire worthless.

Option Seller (Writer)

On the other hand, the seller (writer) of an option is obligated to fulfill the obligations of the contract if the option is exercised. But, if the option is not exercised, then the seller (writer) doesn’t have to do anything, and keeps the option premiums as profit.

In the case of a call option on stock, the seller (writer) has given someone the right to buy the underlying asset. The seller of the call option will be obligated to sell the stock to the call option owner if the option is exercised. The owner of the options literally has the right to CALL the stock from you.

With a put option on a stock, the seller of the put option has given the right to sell that stock to another party. The seller of the put option is therefore obligated to buy the stock from the put option owner if the option is exercised. The owner of the options literally has the right to PUT the stock to you.

Options In Our Everyday Life

An option is simply a derivative of an asset. It derives or gets its value from an underlying asset – like a stock. Most people are already familiar with them but just don’t know it yet. Did you know that you are using a form of options as part of your daily life? Have you purchased insurance as a safeguard against a fire in your home, a crash in your car, or large medical bills? Do you pay a premium for your house, auto, and medical insurance? Then you have purchased a type of option. The fact is, options are a part of our everyday life, and have valuable application in our trading and investing.

Auto insurance, health insurance, and homeowner’s insurance are all examples of put options. These options transfer the risk of loss from the owner of an asset to the writer (seller) of the put. Insurance companies are basically put option dealers. And since we know that insurance companies are some of the most profitable companies around, why not learn to invest in options like they do?

The Power Of Leverage

Leverage is the term used to describe the profit or loss potential when a small amount of money controls a large amount of money. The most common form of leverage is that used by people to buy a new house. They put down a small amount of money and control a very large asset.

With options, the owner of one call option has the upside potential of 100 shares by investing a smaller amount of money rather than purchasing all the stock outright. If there is a 10% rise in the stock, the option can double in value. A word of caution: leverage also increases our risk. A 10% decline in the stock can result in the total loss of what we paid for an option. Don’t worry though; these are problems for option buyers not option sellers (writers).

Basic Option Example

Purchase 100 shares of ABC stock @ $32 for a cost of $3,200. If the stock rises from $32 to $42 you would have a $1000 gain or a 31% increase.

When comparing the stock purchase to the option purchase, your stock purchase will have a moderately high dollar profit. But your option purchase will have a significantly higher percentage return. Of course, for option buyers the reverse is true if the stock moves against your position.