What Is An Option?

Did you know you may be using a form of options as a part of your everyday life?

Do you pay a premium every quarter for house, auto, and medical insurance?

You have purchased insurance as a safeguard against a fire in your home, a crash in your car, or large medical bills. Some investors use options on stocks or cash indexes to protect and insure the value of their portfolios.

A major advantage of options is their versatility. They can be as conservative or as speculative as your investing strategy dictates. Options enable you to tailor your position to your own set of circumstances. Consider the following benefits of options:

• You can protect stock holdings from a decline in market price.
  
• You can increase income against current stock holdings.
  
• You can prepare to buy stock at a lower price.
  
• You can position yourself for a big market move even when you don’t know which way prices will move.
  
• You can benefit from a stock price rise without incurring the cost of buying the stock outright.

What Is An Option?

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset). An option is a security just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties. Listed options have been available since 1973, when the Chicago Board Options Exchange, still the busiest options exchange in the world, first opened.

Options vs. Stocks

In order for you to better understand the benefits of trading options, you must first understand some of the similarities and differences between options and stocks.

Similarities:

Listed Options are securities, just like stocks.

Options trade like stocks, with buyers making bids and seller making offers.

Options are actively traded in a listed market, just like stocks. They can be bought and sold just like any other security.

Differences:

Options are derivatives, unlike stocks (i.e. options derive their value from something else: the underlying security).

Options have expiration dates, while stocks do not.

There is not a fixed number of options, as there are with stock shares available.

Stock owners have a share of the company, with voting and dividend rights. Options covey no such rights.

There are only two kinds of options: Call Options and Put Options.

Call Option
A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call Options are like security deposits. If for example you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call Options usually increase in value as the value of the underlying instrument increases.

When you buy a Call Option, the price you pay for, called the option premium, secures your right to buy that certain stock at a specific price, called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium.

Put Option
Put Options are options to sell a stock at a specific price on or before a certain date. In this way Put Options are like insurance policies.

If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your insurance policy to regain the insured value of the car. In this way, the Put Option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk.

With a Put Option, you can “insure” a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus “damages” your asset, you can exercise your option and sell it at its “insured” price level.

If the price of your stock goes up and there is no “damage,” then you do not need to use the insurance, and once again, your only cost is the premium. This is the primary function of listed option, to allow investors ways to manage risk.

Hopefully this brief insight into Options gave your enough information for you to be able to decide whether or not Options are something you would like to learn more about.