This is a basic explanation of options – what they are, why they exist, how they work, and some basic terms like call, put, or underlying security.
Options Around Us
Let’s ask the very basic question that is frequently asked by people who don’t know much (or anything) about options. So, what is an option?
You’ve heard that word many times. You’ve heard people talking about it in TV news, when another evil CEO made millions on stock options, while letting the company go bankrupt and employees lose their jobs soon afterwards. But options are not always that bad. In fact options are good when you have them and not so good when you don’t.
Option Means a Possibility, a Choice You Have
As you know, option is not just a finance-related term. How long is it since you last asked yourself: “What can I do? What options do I have now?” In such case, option means a possibility, a choice you have. You can do A or you can do B. When you have options, you have the power to choose, to influence the state of the world in some kind.
Option = Right to Buy (or Right to Sell)
It is exactly the same with the financial world options – an option represents the power, the right to choose. When you own an option, you can choose whether to buy an asset or not, or (with different type of options) whether to sell an asset or not.
When you own an option you have the right to buy or sell, but not the obligation. You only do what is favorable for you at that moment. Because of this power of choice, having an option is a good thing and that’s why every option has its price, as it represents a value.
Options Are Securities
Firstly, option is a security. You can own it and you can trade it. When you’re buying an option, you pay for it. When you’re selling an option, someone else pays and you get the money. Every option has its price which is generally positive (though in many cases the price is virtually zero).
Options Are Derivatives
Secondly, option is a derivative. Derivative is a security, whose price is derived from the price of another security (this is the asset that you choose to buy or sell when you own the option). This means that if that another security’s price moves by some amount, the price of the option also moves and there is a specific (and often complicated) relationship between the two. That another security can be a stock, a currency, a rate, a commodity, and many other things. We refer to such security as to the underlying. If the underlying asset wouldn’t exist, the derivative security would have no value only by itself, as there would be no sense in owning it.
Underlying Asset of an Option
Not to get lost in this complicated definition, let’s illustrate it on an example. We all know Microsoft and we all probably know that its shares are listed on a stock exchange and people trade the Microsoft stock. Besides the shares of stock, you can also trade options on the stock. Microsoft stock is the underlying for the options in this case.
These options are securities which provide their owner with the right to buy Microsoft stock for a given price. There are also other options which give its owner the right to sell the stock instead. These are the two basic types of options: right to buy and right to sell.
Call Option = Right to Buy
Call options represent the right (but not the obligation) to buy the stock (or the underlying in general). So you have 2 possibilities when you own a call option:
- You can buy the stock.
- You can do nothing.
Put Option = Right to Sell
Put options represent the right (but not the obligation) to sell the stock (or the underlying in general). So you have 2 possibilities when you own a put option:
- You can sell the stock.
- You can do nothing.
Exercise or Not? Making the Decision
How do you decide what to do? Most economically rational people decide based on the financial outcome of the two choices – select the one that represents more money to them. In different tutorials we discuss how to tell which one it is in a particular situation.
If you are totally new to options and still don’t fully know what they really are after reading this, don’t worry. Options are among the most complicated financial instruments to understand in the first moment. But after you read about a couple of other basic principles of options, you will definitely start to get the picture and soon you will realize that they are actually quite straightforward.
First, you should understand the concept of strike price and intrinsic value.