Weekly Column
by Mark D. Wolfinger
Column 2
What is an Option?
What Can You Do With It?
March 27, 2002
This is the second in an ongoing series of articles about stock options. This week the discussion is introductory, as we discuss what an option is and how an option is used.
An option is a contract between two people: the buyer and the seller. The price the buyer pays to the seller is called the premium.
The buyer of the option has the right to either buy or sell a specific item at a specific price. The option is valid for a specified period of time.
There are two kinds of options:
- Call option: the right to buy
That's all there is to it. It's a very simple concept.
- Put option: the right to sell
Options are common in our lives, but most of us do not realize it. Did you ever go to a supermarket to buy an item on sale only to find the store was out of the item? Did you receive a rain check from the customer service department? If yes, then you are familiar with options, for the rain check is a call option.
That rain check gives you the right to come back to the store to buy that sale item (the specified item) at the sale price (the specified price). The rain check has an expiration date, after which it is no longer valid. The supermarket gave you that rain check for free, so you “bought” the option for a price of zero (premium).
Note, the owner of the option has the right – but not the obligation – to buy the item. If the owner of the rain check decides not to come back to the store to buy the sale item, that is okay. He is allowed to use the rain check, or not use it, at his discretion. That is why the owner of the option is said to have “rights.”
On the other hand, the seller of the option, or the supermarket in our example, is “obligated” to sell the sale item at the sale price if the option owner delivers the rain check to them.
Thus, we see the first property of the call option: the buyer of the option has rights and the seller has obligations. The buyer has the choice of whether or not to “exercise” his option and claim those rights. If he fails to exercise his option by the specified date, then the option “expires” and can no longer be used.
There are many other examples of call options that we take for granted. A bus or train transfer is a call option, for it can be used (or not, at the transfer owner’s discretion) to obtain a free (specified price) ride (specified item), as long as it is used before the expiration.
There are certain terms that we use when discussing options.
- Underlying – the item that the option owner can buy or sell
- Strike price – the price at which the underlying can be bought or sold
- Premium – the cost of the option
Put options are not as common as call options in our everyday lives, but one example is an automobile insurance policy. When you buy collision insurance, you are buying the right to sell your car (underlying) back to the insurance company for the strike price (the amount for which the car is insured) in the event that it is “totaled” in an accident, as long as you do it while the policy is in force (before the expiration date).
- Exercise – the process of claiming the rights specified in the contract. This is accomplished by notifying the option seller that you are going to buy/sell the underlying at the strike price
Summary:
- A call option is the right to buy the underlying at the strike price before the expiration. The call owner exercises his rights when he notifies the option seller that he is going to buy the underlying for the strike price
- A put option is the right to sell the underlying at the strike price before the expiration. The call owner exercises his rights when he notifies the option seller that he is going to sell the underlying for the strike price
When we use options in the stock market, they work in the same way. In those cases, the underlying is stock. We will discuss more about stock options in the coming weeks.
To learn about our book, click here .
Feedback appreciated: Comments or questions:Previous Articles