Options

Options are security instruments which allow the holder of an option to exercise her right to either purchase or sell underlying security at a predetermined price before the expiration date. For simplicity sake, I will assume the underlying security are “stocks”.

There are 2 types of options : “Call” and a “Put”

Call : Gives the holder of this option a right to buy the stock at predetermined price. She can only exercise her rights as long as the option has not expired. To use options lingo - ABC Feb 08 65 Call means that this call option is for ABC company, which expires in Feb’08 and it gives the owner (buyer) of this option a right to buy ABC company’s stock at $65 dollars from seller of the option.

Put : Gives the holder of this option a right to sell the stock at predetermined price. She can only exercise her rights as long as the option has not expired. To use options lingo - ABC Feb 08 70 Put means that this Put option is for ABC company, which expires in Feb’08 and it gives the owner (buyer) of this option a right to sell ABC company’s stock at $70 dollars to the seller of the option.

It may sound a little bit complicated initially but it is not. Basically, it is a contract between two parties to execute a transaction before the expiration date. The seller of the option gives a promise to the buyer of the option. The buyer of the option pays the seller an amount, basically she (the buyer) is compensating the seller for making the promise.

Hypothetically speaking, if options were printed on a piece of paper, they would read something like this :

Call Option :

I promise to sell XYZ stock to the owner/buyer of this option at X price. This promise is only valid until (3rd Friday of January 08).

Put Option :

I promise to buy XYZ stock to the owner/buyer of this option at X price. This promise is only valid until (3rd Friday of January 08).

Typically, in US markets, for a given month the options expire on 3rd Friday of that month. American Options can be exercised any time before the expiration date, European options however can only be exercised “on” the expiration date.

Exercising an option : This means that the owner of the option is asking the seller of the option to fulfil her promise. If the owner of the options does not exercise his right before the expiration date, the option is worthless. I.e.: it does not have any monetary value.

I will write more on how options can be used to leverage existing stock position in your account later. A ton of options information exists on The Options Industry Council website.

This entry was posted on 25 Jan 2008 at 15:16 and is filed under Personal Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or trackback from your own site.