AccountingTrading Options - The Basics (Part One)
Definition Mumbo-Jumbo
Options, unlike stocks, are derivatives. That means that their value derives from the value of another financial instrument (called the underlying). The underlying can be a stock or futures contact or an index. For the purpose of this article we'll concentrate on stocks.
An option is a contract between two parties, the writer (the seller) and the buyer. An option gives the buyer the right to either buy or sell a stock at a pre-determined price. And so there are two types of options corresponding to those rights: calls and puts.
Example for Call Options
Say you go to the farmers market and find a stand where they sell some nice apples. You go to the farmer ask him how much a pound costs and he says 3$. You reach for your wallet and you notice you forgot it at home. The only cash you can find is some 30c in your pocket. So you say to the farmer "Sorry man, forgot my wallet. Can you put away a pound for me and I'll be back in two hours to pick it up." The farmer answers, "Nah, I won't. I might sell it before then." And then you say, "Ok, all I got is 30c. I'll give that to you now and when I come back I'll pay the full 3$. All you have to do is keep it for me for 2 hours. If I don't come back you can still sell to somebody else". To which the farmer agrees because he's going to be around anyway and he'd make 30c profit.
So what just happened is that you and the farmer entered a contract. The farmer "sold" to you the right to buy 1 pound of apples. This right cost you 30c and it is valid for the next two hours (assuming the farmer is an honest man).
Translating this into options jargon: you bought a call option on 1 pound apples at a strike price of 3$. The premium you paid for that option is 30c. Expiry of those options is two hours from now. After that time they will be worthless. You can exercise that right within those two hours and buy the apples for 3$. You can also choose not to exercise it. In both cases the 30c premium is non-refundable.
Let's continue our example. Say that after you leave a big queue starts to form at the farmer's stand. The farmer notices that his apples are very popular so he decides to be cheeky and to raise the price to 4$ a pound. You come back and discover that the price is higher.
You have two choices: you can claim your right to buy a pound at 3$ instead of the current price. The farmer would honor his obligation and sell the apples to you. OR, you can go to someone in the queue and tell him "Look man, an hour ago this guy was selling the apples for 3$ a pound. I have an agreement with him to buy a pound at 3$. If you give me 50c I'll talk to him to sell to you for 3$ instead of 4$." A quick calculation reveals that a pound at 3$ plus 50c premium is 3.50$ which is still less than the current price at 4$. So the guy agrees to buy the right from you.
Options jargon: you bough the option for 30c. You sold it for 50c. That is a 66% return on your money. And you never even had to buy the underlying (the apples).
And this is exactly what option trading is about. Say you anticipate a price rise. Instead of buying the stock, you buy call options for a fraction of the price of the stock. When the stock advances you sell your options for a profit.
Ok, but what do you do if you expect the price to fall? You buy put options. These are the topic of my next article.