As more people rely on themselves for their financial security learning how to trade options is becoming more popular. This article looks at how options work in the real world.
An option provides a person with the RIGHT but not the OBLIGATION to do something. If that person wants to do that thing then fine. If not then no worries....he doesn't have to.
An option creates a legally binding contract between a buyer and a seller.
The contract grants the buyer the right but not the obligation to buy (if a call) or sell (if a put) 100 shares of stock at a set price within a specified date in the future for a premium.
What this means is that the seller must sell or buy the 100 shares of stock at the set price if the buyer exercises the option.
If this is the first time you have been introduced to this concept then I can appreciate what I have just said might sound a bit scary. Therefore lets now look at each component.
1. The Buyer and Seller
The person who buys the option is, obviously, known as the buyer of the option. He owns the option.
The person who grants the option is the seller.
Now note there is ALWAYS a buyer and seller in any option transaction. Think about it, if you buy an option then somebody must have sold it to you!! And when you close a position by selling it then somebody must have bought it off you.
One option is called "a contract".
2. Buying or Selling Stock
There are two type of options:
a) a Call Option which gives the buyer the right to buy the shares
b) a Put Option which gives the buyer the right to sell the shares
3. Shares of Stock
This is the stock on the stock market to which the Option relates. It could be IBM, Google, GE etc.
One option contract (whether it is a Call or a Put) always gives the right to buy (or sell) 100 shares of the stock in question.
For example if I buy one Call contract on IBM then I have the right to buy 100 shares in IBM. If I buy four Call contracts in IBM then I have the right to buy 400 shares in IBM (4 x 100). 8 contracts is 800 shares, 11 contracts 1,100 shares etc.
If you read the text books on options trading then the stock is also called the "underlying instrument".
Also note that each stock which is listed on a recognized share exchange will have its own ticker symbol. For example the symbol for Google is "GOOG"; for Wal Mart it is "WMT". Look at any major financial news website to get the ticker symbols for all the major companies.
4. The Set Price
This set price is the price at which the stock can be bought (call) or sold (put) if you exercise the Option.
This set price is also known as the "strike price". Options are available at a large variety of strike prices.
5. A Specified Date in Time
An option must be exercised or sold to another option buyer before the specified date passes. If it isn't then the option will expire worthless. After the specified date has passed the option will have no value. This specified date is known as the expiration date.
The point you must understand here is this; the life of an option is limited. Once the expiry date passes the option ceases to exist and will have no value .
6. The Premium
The Seller will not grant the Option to the Buyer for free. He will expect a fee for his troubles.
This fee is known as the premium. For a Buyer this fee represents his maximum risk in the transaction. If the option expires worthless this is the maximum amount of money he can lose.
And that is how options work.
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