What are Options?
Options are a form of derivatives, meaning that they derive their value from another source. There are two basic types of options: Call Options and Put Options. A call option gives you the right (but not the obligation) to buy an asset at a specific price within a specific period of time. A put option gives you the right (but again, not the obligation) to sell an asset at a specific price within a specific period of time. A put option is the opposite of a call option. The housing industry provides an example of how this concept works:
Suppose that you are interested in buying a house that is selling for $100,000, but you can’t afford to buy it today. What you can do in this situation is contact the owner and agree to a contract giving you the right to buy the house for $110,000 within the next 6 months (a call option). In exchange for the flexibility of this contract, you pay the current homeowner a downpayment of $5,000 for the right to buy the house.
For the next six months, no matter what happens to the value of the house, you still have the right to purchase the house at the $110,000 price set in the contract. During that time period, the value of the house could have either gone up or down. If the price of the house shot up to $200,000, then you would still have the right to buy it at $110,000 and keep the rest as a profit. If the price of the house fell to $80,000, you still have the right to buy it at $110,000, but you would choose not to exercise that right. Your losses would be limited to the $5,000 premium you paid to get the contract.
Now let’s introduce the options terminology. The $5,000 “downpayment” for your options contract is called the premium. It is the price you pay for the option. The $110,000 exercise price of your housing options contract is called the “strike price” of the option, and your breakeven price would be $115,000 (or $110,000 strike price + $5,000 premium).
In the case of a stock option, the value of the option is determined by the value of the stock it is tied to. From the example, the value of your option is tied to the value of the house. If the value of the house turns out to be less than your breakeven price, then your option has no value. If the price of the house became $200,000, then the value of your option on the house would be $85,000 (or $200,000 - $115,000 breakeven). When the price of the house is below the strike price, the option is “out-of-the-money,” and when it is above the strike price it is considered “in-the-money.”
So when you buy an option on a stock, you are not trading the actual stock, but only the right to trade the stock. You can think of this as indirectly trading the stock. This creates some unique risks and benefits that you wouldn’t have from directly trading the stock.