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Options Trading Basics: What Is An Option?

By Edited Nov 13, 2013 0 0

If you are new to the world of option trading then the terms and the amount of information can seem overwhelming at times but in reality it is quite simple. Some times it is easier to explain new ideas in terms of things that we may be more familiar with. So with that in mind, let's embark on a simplistic description of what an option is.

Options Example From the Real World

Let's consider the world of real estate. If you were look for a house to rent and sometime in the near future you would like to buy your own home then you might be looking for a house that someone will rent to you with the option to buy the home at some point in the future. For the right to possibly buy the home they might charge you $500 - $1000. This would be considered an option. If your lease was for one year then you have paid for an option to buy the house for an agreed upon price at the end of your year lease.

That option is a contract between you and the potential seller of the house. At the end of the year, you can choose to exercise your option and buy the house or you can choose to walk away and lose you $1000. You have no obligation. If you decide to buy the house the seller does have an obligation. He must sell the house to you at the agreed upon price. If you had agreed upon a price of $175,000 but the average house in the neighborhood is now selling for $190,000, it doesn't matter. The seller must still sell you the house for $175,000.

Components Of An Option

Stock options and futures options are really no different than the scenario that was just described. In the example above you would have purchased a call option and the owner of the house would have sold a call option. A call option give the purchaser of the option the right, not the obligation, to purchase the underlying asset for an agreed upon price on or before a particular date in the future. The seller of the call option has an obligation to the contract if the purchaser decides to exercise.

Each option contract is comprised of four difference factors: 1) the underlying instrument or class symbol (thankfully this is one and the same for stock options now), 2) the expiration date, 3) the strike price or exercise price and 4) the type of option (put or call). All of this information together is called an option series. An underlying asset will have a number of series. In fact, some stocks can have more than a hundred series.

A sample series for DELL Computer using each variable would be “DELL May 15 Call.” This tells you that this is a call option for DELL Computers with a strike price of 15 and an expiration in May. Expiration dates for stocks are always the Saturday following the third Friday of the month.



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