Options 101 -part 1

The definition of an option goes something like this – “a contract that gives the right but not the obligation to buy (call) or sell (put) a certain amount of an underlying commodity or financial instrument by or at a certain date in the future”. An option is a type of derivative, since it’s value is derived from the underlying security (a stock) or commodity. To simplify let me use the word option only in the context of stock prices. The price of an option depends on the underlying stock price movements. For example, value of a call option goes up when underlying stock price goes up and vice versa. Let’s look at in another way. As of today’s closing Apple (AAPL) stock price is $257.81. So, a call purchased for 260 strike September expiration would give the buyer right to buy AAPL for $260.00 no matter how high the stock price goes beyond the 260 strike price before September 17th.  The subject of options is quite complex at times and very confusing more often. Before getting into higher complexity let me explain it in a more common way (following example has been used by many people in many places for easy understanding of how options work).

Let’s say you have come across a house listed on sale for $80K. Your intuition about macro economy tells you that this house would sell for $100K in about 6 months from now. Your intuition gains more strength as an inside source tells you that government will stimulate economy by another $1 T. While you are thinking about that deal you notice a significant increase in new job hires, correlating it to an upcoming healthy economy and start of a housing market boom. As you are more confident about the house should be $100K in near future you want to strike a deal (option) with the seller to buy the house for $80K (strike price) before the price goes up. Then, you realize that you cannot come up with $80K so, you ask the seller for a month’s (expiration) time to come up with the money. At this point the seller asks for a guarantee (option price) that you will come back with money in a month. Since, you think in 6 months the house value will be much more than the offer you agree to pay $2K to the seller for a month’s wait (time value). This is similar to buying a call option on a stock. Within the agreed one month’s time if you cannot come up with the $80K, you will stand to lose $2K paid to the seller (option expired worthless). If, you do come up with the money the seller has to oblige your right to buy the house at $80K (option exercise), even if the market value of the house is higher than $80+2K.

That was a little gist about what options are. I will get to more complex part of the options in the following posts as I don’t want to an information overload here. Somewhere, I will also include a glossary of sort to familiarize with the options trading lingo.

This post was written presuming the reader will have some knowledge about trading stocks but is not yet into the OPTIONS world. As always don’t forget to leave comments and check back for the next post and learn all about options free. If you are already an options trader I honestly welcome your suggestions.