Understanding Options

Options are one of the oldest trading vehicles man has ever used. Around a 1000 B.C Aristotle Thales predicted by the stars that there would be a bumper olive harvest and bought options on the use of olive presses. When the harvest did in fact prove to be a great harvest Thales was able to rent the presses at a significant profit.

When you buy an option you have the right but not the obligation to buy (call) or sell (put) a specific underlying asset at a prearranged price on or before a given date. Similar to futures, options can give the holder protection against adverse price moves. Call options when bought allow you to buy an asset at a fixed price (strike price) on or before a specific exercise date. Exercise date: some options can only be exercised on a particular date and they are commonly know as European options. Options that can be exercised on or before the due date are commonly known as American options). A Put options is the reverse of the call option.

When you buy a put option it gives you the right but not the obligation to sell an underlying asset at a predetermined date. Options are frequently used in real estate deals. A property developer may take the option on a piece of land he wants to develop.

He may for example buy (call) the right to purchase a particular piece of land at $100,000 on or before sixty days beginning on the day he takes the option. For the privilege of fixing the price for the next sixty days he agrees to give the seller $1000. This now gives him time to arrange any permits he may need to construct the building he wants. He also has the knowledge that he can buy that piece of property at any time in the next sixty days at the price he has already agreed upon.

If for some reason he can not get the permits he needs then he simply does not exercise his option to purchase. He will of course forfeit the $1000 that he paid for the option. The seller in this case was obliged not to sell that piece of land to anyone else for the next sixty days. The same process can be applied to almost anything.

If you apply the example of the property deal to the stock market you get the same situation. Lets assume you buy a call (right to buy) 100 shares of Xyz company at an agreed price (strike price) on an agreed date (expiration date) at say $40 per share and you pay $5 for the option. If on or before the expiration date Xyz is trading at less than $40 per share then you would not exercise your option and you would have lost the price you paid on the option $5.

If Xyz Company is trading at $50 per share on or before the expiration date your option is in effect worth $10. This is the difference between the price you have an option to buy Xyz at in this case $40 and the price it is actually trading at $50. The reverse of this is a put (right to sell) option on an underlying asset. You might feel that the market is overheated at the present time and want to buy a put (right to sell) option. This will give the individual who bought the put option the right to sell that option at and agreed price (strike price) on or before a specific date (expiration date). You can also sell options (as opposed to buying a put).

The writing of call options can be extremely high risk and I would not advise this for new traders until they thoroughly understand their liability. Buying an option either call or put gives you rights, selling (writing) options gives you an obligation. The day after the expiration date an option has no value. At this stage it may seem that the buyer of the option has all the cards but don't forget the seller of the option receives the money for granting the option. The money that is exchanges is commonly referred to as the premium.

Although option trading has more than its fair share of jargon remember the essence of all markets is that there is a buyer and a seller and both believe they have an advantage and have the potential to make money. Think of an option in the same way that you would pay your house insurance company. The premium you pay each month gives you the right to a benefit if some event in the future happens and you decide to exercise your right to have the insurance company pay you for that event. The insurance company on the other hand has the obligation to pay you should you should you exercise that right in exchange for accepting your premium each month.

Martin Chandra is a full-time investor. Get limited offers at here.