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What Are Options?

You may have heard about stock options, but are wondering what they really are.  I’m not talking about the ones your company gives you as an incentive, but stock options that trade actively on the stock market.

 Options are a derivative financial product that is a contract between two parties to conduct a future transaction at a set price.  Sounds complicated, but it in basic practice it is not.  Think of an option as “the option” to buy the specified security (so stock, index, commodity, etc.), at the specified price, on the specified day.  Whew…

 

Types of Options

Options come in two basic types: calls and puts.  A call is the right to buy the underlying security, and a put is the right to sell and underlying security.  Each option is usually the right to buy or sell 100 shares of the underlying security.

The process of actually utilizing an option is called exercising your option, or basically exercising your right to either buy or sell the underlying security.  You do this on the expiration date.  If you don’t exercise your option, or the underlying security never reached the agreed-upon price, your option expires worthless.

You can also write an option.  If you own a stock, you can write an option on your stock.  So, if you own 100 shares of Google, you could write 1 Google call option.  This is called writing a covered call.

Just like stocks, you can buy and sell options through normal trading.  Many options are traded on normal exchanges; however, some individuals create ad hoc contracts to meet the desires of the buyer.  This is the case with Warren Buffett, who wrote several options against indexes for 20 years in the future, in exchange for a premium today.

Options are also considered either “in-the-money”, which means the strike price has been met or exceeded, “at-the-money”, which means the underlying asset is trading at the strike price, or “out-of-the-money”, which means the underlying asset is yet to achieve the strike price.

 

How Options Are Structured

 When you want to go and buy an option, you will notice a peculiar way of structuring them.  Every option has the following specifications:

  • What Type of Options (Call or Put)
  • The quantity of underlying asset (usually 100 shares, but it can vary)
  • The strike price, which is the underlying price the security must reach to be exercised, as well as the price paid for the security
  • The expiration date, which is the last day the option can be exercised
  • The Settlement Terms, which state whether an actual asset must be delivered, or if cash can be tendered (usually only applies to commodities)
  • The price of the option (what you pay for the contract)

Take a look at Google.  It is currently trading around $580.  You can purchase a call option that would expire on February 12, 2012 at a strike price of $580 for about $10.00.  If Google rises above $580, to say $600, your contract becomes more valuable since you could buy the Google shares at $580 even when it trades at $600.

Options for Options

 Does all of this sound complicated?  It is, because while the underlying principal is simple, in practice it’s not.  If you are wanting to trade options, consider using an optionsxpress promotional code and trading in a virtual account before trading real money.  This will give you hands on practice to get the hang of things.

 

7 thoughts on “What Are Options?

  1. I write put options when there aren’t many good values on the market.

    It’s a good way to keep cash reserves aside, and earning a respectable rate of return, and ready to jump back into the market when the time is right.

    Not for everyone, though.

  2. Using a virtual platform is a great way to learn about financial trading tools that aren’t familiar to you. This way you can gain the experience without the added stress of losing money.

  3. I can appreciate a good blog post that isn’t afraid to get technical. Thanks for the lesson. I’ve been reading up on options, but haven’t made the plunge quite yet. I’m still trying to master stocks (as if you ever really fully can!)

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