What Are Options - Part 1

What Is An Option?

In the world of investing and finance, there are many terms and concepts that are often misunderstood by many investors.

Some commonly misunderstood issues include the concepts of selling stock short, what a derivatives contract is, credit default swaps, and dividend arbitrage strategies.

One of the more common concepts that is misunderstood by investors is the options contract.

What Exactly Is An Option Contract?

While an option contract may seem confusing at first glance, it is actually far simpler than it is made out to be.

Let's start with a very basic definition of what an option is:

An option gives the buyer the right but not the obligation to buy or sell the underlying at a certain price by a certain date in the future.

An option is exactly that-the option to be long or short the underlying at a certain price by a certain date in the future.

An option contract is always based on an underlying contract or shares. In the case of stock, one option contract equals 100 shares of the stock.

In futures, one option equals one contract of the underlying future.

Options Have Set Price Levels Called Strike Prices

Options always entail a specific price which is called the strike or striking price.

This option strike price is the price at which one may have the right to buy or sell the underlying contract.

The strike price is often referred to as the exercise price.

An option will always have a strike price.

Some underlying contracts will have more strike prices than others.

Inexpensive stocks for example, may have strike price increments of $2.50 while more moderately priced stocks may have increments of $5.00 with very expensive stocks having even larger increments.

Let's look at an example:

Let's suppose that an investor is trading shares of TTT which is currently trading at $25 per share.

Let's further suppose that this investor believes that the shares may rise in the near future but does not want to commit the necessary capital to buy the shares outright.

The investor may elect to purchase a call option instead. In this particular case, the investor may elect to purchase the front month $27.50 call option.

This call option would give the investor the right but not the obligation to buy the shares or be long the shares from $27.50 at any time until expiration.

Let's assume that after the investor buys this option that the shares skyrocket to $30 per share.

If the investor has the right to be long from $27.50, then the investor would be looking at a gain on the shares of $2.50 per share minus whatever premium he or she paid for the option.

Although we will address call and put options more specifically in future articles, it is very important that one have a thorough understanding of how an option works before looking to utilize options strategies.

To continue to Part 2 of this series, Click Here