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What Are Stock Options?

By Edited Sep 19, 2015 1 3

One reason life is so great is because it is full of options. What to wear? What to eat? Who to date? (Although that hasn't always been a choice throughout history!) But perhaps my favorite of all are stock options! What is an option you might ask? Keep reading and find out.

A stock option contract is a legally binding contract between a buyer and a seller. No different than when you go to the Starbuck's to buy your morning coffee. The seller (Starbucks) offers you (the buyer) a price and you accept (Lord knows whyJ). Options come in two different varieties as well: calls and puts. Let's take a closer look at the two different sides of this age old accord.

The buyer of a call option has the right to buy shares of stock at a fixed price over a specified period of time. The buyer is anticipating an increase in the value of the underlying company. Buyers of put options buy for the opposite reason. They anticipate a downward price move of the underlying, and as a buyer receive the same rights as call purchasers. Buyers of options are considered long in their position while option sellers are called short.

No, this has nothing to do with anyone's height. Option sellers are short because they are selling a commodity that they do not own, in this example stocks. Just like when you ask your friend to loan you some money only to have them reply that they are short on cash. Only in the investing world when you're short you are borrowing someone else's goods. This may sound shady, but not only is it accepted, it happens many times each market day. Option sellers receive a premium for this transaction. So option buyers fork out money to hold their position and option sellers receive money. The reason for this is because the option seller has the obligation to fulfill the terms of the contract should those terms be reached. This is a key concept. The option buyer has rights and option sellers have obligations.

You may now be thinking, "Michael, that sounds like a big commitment."

Well I have good news. You can get out of a contract with ease (assuming there is no problem with liquidity). If you buy an option then you must sell to exit the agreement, and if you sold you must buy. This is called the closing transaction, or the reverse trade, and this is how the vast majority of option contracts are ended on the stock market. This may sound a little confusing, but it's really just a form of cancelling each other out. Buying and selling are by their nature opposites. Just as 0ne is the opposite of negative one and when you add them together you get zero.

Here are some key points for you to remember:

1: There are two types of options: calls and puts

2: Buying represents a right and selling represents an obligation to fulfill (Think of insurance policies)

3: Option contracts are legally binding agreements, but can be cancelled anytime before their predetermined expiration date

So next time you're out at your local Starbucks be sure to remind the staff of their obligation to deliver good service. Till next time…



Jan 14, 2011 2:15pm
Very interesting topic....thanks!
Jan 15, 2011 9:05am
Thank you manspaugh. I hope that since this is like only my third article to ever be published that I have room for much improvement. I'm about as green as it gets when it comes to writing things that others may actually read.
Aug 27, 2013 8:08am
Very informative, thanks!
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