Options Basics: What Are Options?

Options are a type of derivative security. They are a derivative because the price of an
option is intrinsically linked to the price of something else. Specifically, options
are contracts that grant the right, but not the obligation to buy or sell an underlying asset
at a set price on or before a certain date. The right to buy is called a call option and the
right to sell is a put option. People somewhat familiar with derivatives may not see an
obvious difference between this definition and what a future or forward contract does.
The answer is that futures or forwards confer both the right and obligation to buy or sell
at some point in the future. For example, somebody short a futures contract for cattle is
obliged to deliver physical cows to a buyer unless they close out their positions before
expiration. An options contract does not carry the same obligation, which is precisely
why it is called an “option.”

Call and Put Options

A call option might be thought of as a deposit for a future purpose. For example, a land
developer may want the right to purchase a vacant lot in the future, but will only want to
exercise that right if certain zoning laws are put into place. The developer can buy a call
option from the landowner to buy the lot at say $250,000 at any point in the next 3
years. Of course, the landowner will not grant such an option for free, the developer
needs to contribute a down payment to lock in that right. With respect to options, this
cost is known as the premium, and is the price of the options contract. In this example,
the premium might be $6,000 that the developer pays the landowner. Two years have
passed, and now the zoning has been approved; the developer exercises his option and
buys the land for $250,000 – even though the market value of that plot has doubled. In
an alternative scenario, the zoning approval doesn’t come through until year 4, one year
past the expiration of this option. Now the developer must pay market price. In either
case, the landowner keeps the $6,000.

A put option, on the other hand, might be thought of as an insurance policy. Our land
developer owns a large portfolio of blue chip stocks and is worried that there might be
a recession within the next two years. He wants to be sure that if a bear market hits, his
portfolio won’t lose more than 10% of its value. If the S&P 500 is currently trading at
2500, he can purchase a put option giving him the right to sell the index at 2250 at any
point in the next two years. If in six months’ time the market crashes by 20%, 500 points
in his portfolio, he has made 250 points by being able to sell the index at 2250 when it is
trading at 2000 – a combined loss of just 10%. In fact, even if the market drops to zero,
he will still only lose 10% given his put option. Again, purchasing the option will carry a
cost (its premium) and if the market doesn’t drop during that period the premium is lost.

These examples demonstrate a couple of very important points. First, when you buy an
option, you have a right but not an obligation to do something with it. You can always let
the expiration date go by, at which point the option becomes worthless. If this happens,
however, you lose 100% of your investment, which is the money you used to pay for the
option premium. Second, an option is merely a contract that deals with an underlying
asset. For this reason, options are derivatives. In this tutorial, the underlying asset will
typically be a stock or stock index, but options are actively traded on all sorts of financial
securities such as bonds, foreign currencies, commodities, and even other derivatives.

Buying and Selling Calls and Puts: Four Cardinal Coordinates

Owning a call option gives you a long position in the market, and therefore the seller of
a call option is a short position. Owning a put option gives you a short position in the
market, and selling a put is a long position. Keeping these four straight is crucial as they
relate to the four things you can do with options: buy calls; sell calls; buy puts; and sell
puts.

People who buy options are called holders and those who sell options are
called writers of options. Here is the important distinction between buyers and sellers:

 Call holders and put holders (buyers) are not obligated to buy or sell. They have
the choice to exercise their rights if they choose. This limits the risk of buyers of
options, so that the most they can ever lose is the premium of their options.
 Call writers and put writers (sellers), however, are obligated to buy or sell. This
means that a seller may be required to make good on a promise to buy or sell. It
also implies that option sellers have unlimited risk, meaning that they can lose
much more than the price of the options premium.

Don't worry if this seems confusing – it is. For this reason we are going to look at
options primarily from the point of view of the buyer. At this point, it is sufficient to
understand that there are two sides of an options contract.
Options Terminology

To understand options, you'll also have to first know the terminology associated with the
options market.

The price at which an underlying stock can be purchased or sold is called the strike
price. This is the price a stock price must go above (for calls) or go below (for puts)
before a position can be exercised for a profit. All of this must occur before
the expiration date. In our example above, the strike price for the S&P 500 put option
was 2250.

The expiration date or expiry of an option is the exact date that the contract terminates.

An option that is traded on a national options exchange such as the Chicago Board
Options Exchange (CBOE) is known as a listed option. These have fixed strike prices
and expiration dates. Each listed option represents 100 shares of company stock
(known as a contract).