Options Basics- What Are Options

This is a mini series on Options, do not take any of this as advice or recommendation for buying or selling options. We will cover some basics of options, what are options? how do options work? and we’ll look at just a few simple options strategies in the next step.

What are options?

Call Option vs Put Option for option BUYEROptions are known as derivative instruments, that is because their value is derived from the underlying asset. The value of a stock option for example depends (mainly) on  the stock (the underlying asset).

This can get a little tricky so pay close attention:

A CALL Option gives the BUYER of the option the option of buying the underlying security, a PUT option gives the BUYER of the option the option of selling the underlying security.

There is NO OBLIGATION on the BUYER to do either one. Basically if you buy an option (call option or put option) you are giving yourself the option to either buy or sell the underlying stock alternatively you can simply choose to expire the option without doing anything.

To make it a little easier think of it this way: If you are buying a call options you are calling the stock over, if you are buying a put option you are putting the stock on someone else.

Call Option vs Put Option for option SELLER

If you are selling options things are a little different, the seller collects a premium for when the option is sold that is how a seller profits.

A SELLER of a CALL option has the obligation to SELL the underlying security if the option is exercised by the holder. A SELLER of a PUT option has the obligation to BUY the underlying security if the option is exercised by the holder. You might want to take a minute to digest that, it can get a little confusing.

Here is a little table to make it a little easier for you:

[Table=13]

The Option Contract
The option contract is based on 100 shares of the stock so when you buy or sell an option, upon exercise 100 shares must be bought/sold per contract.

Here is an example of Microsoft option contract. This is what a typical options contract looks like

1 January 2010 $2.40 MFST call at $20

1= The number of contracts you want to buy, in this case 1
January 2010 = When the option expires, this option expires in January 2010
$2.40 = The price of the contract, you must multiply it by 100 since each option consists of 100 shares so in our case the 1 contract would cost $240 (or you would collect that amount if you sold the option)
Call = The type of option, this is a Call option which gives the buyer the right to buy and seller the obligation to sell.
$20 = This is the strike price it’s the price at which you can purchase the stock, for our example the strike price is $20/stock if exercised the buyer pays $2000 for 100 MFST shares to the seller.

So if you are the buyer of the option you will pay $240/contract plus any fees your broker charges you and you will have the option to purchase 100 Microsoft shares by January 2010 for $20/share, if you decide not to purchase it you can just let the contract expires and no payments will be due.

If you are the seller of the option you will collect $240/contract minus any broker fees and you are obligated to sell 100 Microsoft shares to the buyer if exercised by January 2010 regardless of what the market price of the stock is.

American Style vs. European Style

American Option Contract can be exercised ANYTIME until the expiration.
European Option Contract can only be exercised ON expiration date.

Options are complicated instruments, I hope this provides some basic understanding of options, next time we will look at some simple option strategies and how they can be used to either protect yourself or increase profits.

Questions or confused? Leave a comment!