What Is an Option
Options are simply legally binding agreements – contracts – between two
people to buy and sell stock at a fixed price over a given time period.
here are two types of options: calls and puts. A call option gives the owner the
right, not the obligation, to buy stock at a specific price over a given period of time.
In other words, it gives you the right to “call” the stock away from another person.
A put option, on the other hand, gives the owner the right, not the obligation, to
sell stock at a specific price through an expiration date. It gives you the right to
“put” the stock back to the owner. Option buyers have rights to either buy stock
(with a call) or sell stock (with a put). hat means it is the owner’s choice, or option,
to do so, and that’s where these assets get their name.
Now you’re probably thinking that this is sounding complicated already. But
options are used under different names every day by different industries. For
instance, we are willing to bet that you’ve used something very similar to a call
option before.Take a look at the following coupon:
The way pizza coupons and call options work is very similar. his pizza coupon
gives the holder the right to buy one pizza. It is not an obligation. If you are in possession of this coupon, you are not required to use it. It only represents a right
to buy. here is also a fixed price of $10.00. No matter how high the price of pizzas
may rise, your purchase price is locked at $10.00 if you should decide to use it.
Last, there is a fixed time period, or expiration date, for which the coupon is good.
Now let’s go back to our definition of a call option and recall that it
represents:
1) Right to buy stock
2) At a fixed price
3) Over a given time period
You can see the similarities between a call option and pizza coupon. If you
understand how a simple pizza coupon works, you can understand how call
options work.
Now let’s take a look at a put option from a different perspective. Put options
can be thought of as an insurance policy. hink about your car insurance, for
example. When you buy an auto insurance policy, you really hope that you will not
wreck your car and that the policy will “expire worthless.” However, if you should
total your car, you can always “put” it back to the insurance company in exchange
for cash. Put options allow the holder to “put” stock back (sell it) to someone else
in exchange for cash. Remember, if you buy a put option, you have the:
1) Right to sell stock
2) At a fixed price
3) Over a given time period
As you will discover, the mechanics of calls and puts are exactly the same; they
just work in the opposite direction. If you buy a call, you have the right to buy
stock. If you buy a put, you have the right to sell stock.
Option Sellers
We know that buyers of options have rights to either buy or sell. What
about sellers? Option sellers have obligations. If you sell an option, it is also called
“writing” the option, which is much like insurance companies “write” policies.
Buyers have rights; sellers have obligations. Sellers have an obligation to fulfill the contract if the buyer decides to use their option. It may sound like option
buyers get the better end of the deal since they are the ones who decide whether
or not to use the contract. It’s true that option buyers have a valuable right to
choose whether to buy or sell, but they must pay for that right. So while sellers
incur obligations, they do get paid for their responsibility since nobody will
accept an obligation for nothing.
here are some traders who will tell you to always be the buyer of options while
others will tell you that you’re better off being the seller. Hopefully, you already see
that neither statement can always be true, because there are pros and cons to either
side. Buyers get the benefit of “calling the shots,” but the drawback is they must pay
for that benefit. Sellers get the benefit of collecting cash but they have a drawback
in that there are potential obligations to meet. What are the sellers’ obligations?
hat’s easy to figure out once you understand the rights of the buyers. he seller’s
obligation is exactly the opposite of the buyer’s rights. For example, if a call buyer
has the right to buy stock, the call seller must have the obligation to sell stock. If a
put buyer has the right to sell stock, the put seller has the obligation to buy stock.
hese obligations are really potential obligations since the seller does not
know whether or not the buyer will use his option. For example, if you sell a
call option you may have to sell shares of stock, which is different from saying
that you will definitely sell shares of stock. A call seller will definitely have to sell
shares of stock if the call buyer decides to use his call option and buy shares of
stock. If you sell a put option, you may have to buy shares of stock. A put seller
definitely must buy shares of stock if the put buyer decides to use his put option
and sell shares of stock.
It’s important to understand that options only convey rights to buy or sell
shares of stock. For example, if you own a call option, you do not get any of the
benefits that come with stock ownership such as dividends or voting privileges
(although you could acquire shares of stock by using your call option and thereby
get dividends or voting privileges). But by themselves, options convey nothing
other than an agreement between two people to buy and sell shares of stock.
Now that you have a basic understanding of call and put options, let’s add
some market terminology to our groundwork.
