For Options Beginners, What Is An Option?

You heard the hype on TV infomercials. You may have seen full page advertisements in the newspaper or received mail filled with get-rich-quick promises. All you have to do is pay a few thousand dollars and attend some seminars. Forget it. That’s not a sound method for learning about the advantages of using options.

Options allow an investor to reduce risk and provide an improved chance to profit from stock market investments. But first, it’s necessary to understand the basic principles behind options. It is important to understand how options work before you consider using them.

What new investors need to know about options:

1. An option is an agreement, or contract, between two parties: a buyer and a seller.

2. Exchange traded option contracts are guaranteed by the Options Clearing Corporation (OCC). There has never been a default in the 36-year history of the OCC.

3. There are two types of options: calls and puts.

4. The option buyer pays a premium to the seller.

5. In return for receiving the premium, the seller grants specific rights to the buyer and accepts specific obligations.

6. A call option grants its owner the right to buy a specific item at a specified price (called the strike price) for a limited time.

7. A put option grants its owner the right to sell a specific item at the strike price for a limited time.

a. The specific item is 100 shares of stock. The generic name is the “underlying asset.”

b. The limited time ends on the option expiration date. Equity options expire on the 3rd Friday of the month, after the market closes for trading (technically expiration is the following morning, but the last time you may sell or exercise an option is the 3rd Friday).

8. An option seller may become obligated to honor the conditions of the contract – i.e., sell stock to the call owner or buy stock from the put owner. If the option expires worthless (see #9), then the option seller is relieved of his/her obligations.

9. What can you do with an option?

a. Sell it. You bought it; you can sell it.

b. Exercise it. This is the process by which an option owner does what the contract allows. Thus, a call owner can exercise the option, and buy 100 shares of the specified stock at the strike price per share – as long as the option has not yet expired. A put owner may sell 100 shares at the strike price. In practice, it’s more efficient to sell an option, rather than exercise.

c. Allow it to become worthless. If expiration arrives and the option has neither been sold nor exercised, it expires worthless.

Mark Wolfinger is a 20 year CBOE options veteran and is the writer for the blog Options for Rookies Premium. He also is the author of the book, The Rookie's Guide to Options.

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Comments

  1. Posted by Kerrie Setiawan on July 25, 2011 at 10:45 pm

    I like the way you have broken down the definition of stock options into bite-sized chunks, easier to understand than those found in many stock market education courses.