What Are Options?

| February 28, 2012 | 0 Comments

An option is a binding financial contract offering strictly defined terms and conditions.  Options contracts give the buyer of the option the right to buy or sell an underlying asset.  The basic terms of the option state the specific price of the underlying asset at which the contract may be executed.  In addition, the option clearly states action must be taken on or before a certain date.

An option, just like a stock or bond, is a security.  And while an option gives you the right to buy or sell the underlying asset, it does not require you to do so.

Let me elaborate a bit…

When you buy an option you own the right, but not the obligation to do something. If the expiration date passes, and you neither sell nor exercise your option, the option contract itself becomes worthless. Obviously, you wouldn’t want to do this as you’d lose 100% of your investment, or premium.

And the premium is what options are all about…

The premium simply means the money you paid for the option. Now, options pricing can be quite complex.  But in the end, the majority of the option’s price is calculated based on four primary factors.  They are asset price, strike price, time to expiration, and volatility.

Options pricing is a fairly in-depth topic we won’t dig into here.   Just understand there are multiple factors affecting your options… not just price.

So now we know what an option contract is, and the variables on how it’s priced.  To trade options you need to know the basic types available… and they are Calls and Puts.

To start, a call gives the option holder the right to buy an asset at a certain price within a specific period of time. Calls are much like having a long position on an asset. Obviously, if you are buying calls your hope is that the asset will increase substantially before the option expires.

A put is the exact opposite of a call.  And puts give you the right to sell an asset at a certain price within a specific period of time.  Again, puts are just like having a short position on a stock.  If you are buying puts, you hope that the price of the underlying asset will fall before the option’s expiration.

Now, to trade options, you’ll have to know the basic terminology associated with the options market.

The price at which an underlying asset can be purchased or sold is called the strike price. This is the price a asset must breach, prior to exercising an option for a profit. And of course, all this must happen before the expiration date.

Finally, you need to consider what you are buying or selling options for… the underlying asset.

When most people think options, they immediately think of stocks.  But stocks aren’t the only asset you can buy or sell options for.  Other assets include futures, stock indexes, ETF’s, currencies, bonds, and even the volatility index (VIX).

For example, you can buy a call option on the Euro.  Or a put option on the VIX.  The list is really endless.

Now that you know a bit more about options basics, you may be ready to dive in.  Before you do, let me leave you with this…

Options can be as speculative or conservative as you want. That means you can use them for protecting a position from a loss, or you can outright bet on the movement of a market or index.  But before trading options, establish and follow a plan based upon your requirements.  Following a plan will increase your odds of success when trading options.

Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.