Options. The Basic Concepts
our abbreviated version of this section: Introduction to Options: The Basics.
A. What is an option?
An option is a contract between two parties, the buyer and the seller.
The price the buyer pays to the seller is the
There are two types of options:
A call option gives its owner the
right to buy something.
option gives its owner the right to
Thus, the option contract gives its owner the right to buy or sell
- a specific item: the underlying asset (usually 100 shares of stock)
- at a specific price:
the strike price
for a specific period of time: from the time the option is bought through
its expiration date
For listed stock options, the expiration date is the
third Friday of the specified month.
The format used to describe an option is:
: IBM Apr 110 call
This represents an option to
buy 100 shares of IBM at $110 per share, any time before the market closes
on the 3rd Friday, next April.
GE Jan 35 put:
An option to sell 100 shares
of GE at $35 per share, any time before expiration,
How does an option work?
An option buyer has
a) The call owner has the right, but not the
the option to buy 100 shares of the underlying stock at the
: You exercise one IBM Apr 110 call.
You pay $11,000 and receive 100 shares of IBM stock.
The price at which the stock is currently
trading in irrelevant: This transaction takes place at the
agreed upon price (strike price).
b) The put owner has the right, but not the obligation,
to exercise the option to sell 100 shares of the
underlying stock at the strike price. Upon exercise of the
option, the exerciser delivers 100 shares of stock and receives the strike
price per share.
: You exercise one MSFT Nov 35 put, You
deliver (sell) 100 shares of MSFT and receive $3,500.
An option seller
If the call buyer exercises the option, then one seller of the
an exercise notice, and is obligated to deliver 100 shares
of the specified stock. For this stock, he is paid
the agreed upon price (strike price) per share.
Why should options be part of your
Stock options can be used in conservatively to
increase the return on your investments
provide protection against a decline in the price of your
allow you to buy stock below current market price
allow you to sell stock above current market price
reduce the fluctuations in the value of your portfolio
- profit from taking a bulliish, bearish, or neutral position on the stock market, or a specific stock
- trade without owning a single share of stock
See The Rookie's Guide to Options
The Beginner's Handbook of Trading Equity Options
for details on how to accomplish these goals using six different option strategies.
Why don't more people use options?
There is a common misconception about options. Although the options
exchanges make a valiant effort to educate individual
investors, many people mistakenly believe options are risky investment tools, suitable only
for speculators. The truth is that it's the investors, not options, who are 'risky,' because they adopt strategies
that have little chance of success.
conservatively, options can provide significant risk reduction and
an increase in the
annual returns of your investment portfolio.
If you can make good profits by using conservative methods, why take unnecessary risk?
Am I now ready to trade?
No. But you are ready to open a paper trading account and practice buying and/or selling a few option contracts to see
what happens. Don't use real money yet. Before trading, you want to be aware of basic
strategies you can use.
Read my personal trading philosophy,
which includes advice for option rookies.
Interested in learning how these remarkable investment tools can work for you?
Tour this site to learn more.