Options: The Basic Concepts

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 premium.

There are two types of options:
A call option gives its owner the right to buy something.
A put option gives its owner the right to sell something.

The option contract gives its owner the right to buy or sell
  • a specific item: the underlying asset (usually 100 shares of stock)
  • 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:

Example : IBM April 110 call:
This represents an option to buy 100 shares of IBM at $100 per share, any time before expiration, next April.
Example : GE Jan 35 put
An option to sell 100 shares of GE at $35 per share, any time before expiration, next January.

B. How does an option work?

An option buyer has rights.
a) The call option buyer has the right, but not the obligation, to exercise the option and buy 100 shares of the underlying stock at the strike price.

          Example: 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 buyer has the right, but not the obligation, to exercise the option and sell 100 shares of the underlying stock at the strike price. Upon exercise of the option, he delivers 100 shares of stock and receives the strike price per share.

           Example: You exercise one MSFT Nov 35 put, You deliver 100 shares of MSFT and receive $3,500.


An option seller has obligations.
If the call buyer exercises the option, then a seller of the option is assigned 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.

If the put buyer exercises the option, then a seller of the option is assigned an exercise notice, and is obligated to buy 100 shares of the stock for the agreed upon price (strike price) per share

C. Why should options be part of your investment portfolio?

Stock options can be used in a conservative manner to
  • increase the return on your investments
  • provide partial protection against a decline in the price of your stock
  • allow you to buy stock at a lower price
  • allow you to sell stock at a higher price
  • reduce the fluctuations in the value of your portfolio
  • take a bulliish, bearish, or neutral stance on the stock market, or a specific stock

See the new book, The Rookies Guide to Options: The Beginner's Handbook of Trading Equity Options for details on how to accomplish these goals using six different option strategies.

D. Why don't more people use options?

There is a 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.

When used conservatively, options provide a significant increase in the annual returns of your stock portfolio. At the same time, the safety of your holdings is increased.

If you are a more conservative investor, you can use other strategies to protect a much greater portion of your assets - at little, or no, cost. Interested,? See The Rookie's Guide to Options.

If you are ready to learn more, you can