Stock Option Basics

An option is a contract between a buyer and a seller. The option is connected to something, such as a listed stock, an exchange index, futures contracts, or real estate. For simplicity, this article will discuss only options connected to listed stocks. An option gives its owner the right to buy or sell an underlying asset on or before a given date at a fixed price. For example, you may enjoy the option to buy a certain apartment on or before 31^st Dec of this year for $5,00,000. On that date even if the market price is more than $500,000 (Say $600,000), the option write will be compelled to sell the house. On the other hand if the price is less than $500, 000 (say $400,000), the option holder is not obliged to buy the house. Options represent a special kind of financial contract under which the option holder enjoys the right, but has no obligation, to do something.

Now let us understand how this instrument originates. The owner of the house may expect that the price of the house will go down (below $500,000). At the same time some buyer expects that the price will go up. Since the owner wants $500,000 for the house, he is willing to write an option. He may sell the option for say $100. Now if the price goes below $500,000 on the expiry date, the buyer will not exercise the option and instead will buy another house for the going market price. The loss is only the price of the option i.e. $100. On the other hand if the price goes up then he will exercise the option and buy the house for  $500,000. If the market price is $600,000 he will make a profit of $99,900 ($100,000-100). On the other hand the owner gets lower than the market price. However remember that he was willing to sell it for $500,000 and was afraid that the price may go down. Hence this instrument originates due to varying perceptions of the buyers and sellers. In the real life options are written for shares, index, etc.

The key terms and phrases employed in discussing options are as follows.

Option holder and option writer: The option holder is the buyer of the option and the writer is the seller of the option. (Remember, option is nothing but a contract which binds both buyer and the seller to do a specific act on a certain date.)

Exercise price and the strike price: The price at which the option holder can buy and/or sell the underlying asset is called the exercise or the strike price. In the above example strike price is $5,00,000.

Expiration date or Maturity date: The date when the option expires or matures is referred to as the expiration date or maturity date. After this date the option is worth less.  In the above example 31^st Dec is the expiry date.

Exercising the option: The act of buying or selling the underlying asset as per the option contract.

European and American option: A European option can be exercised only on the date of expiry, where as the American option can be exercised on or before the date of expiry.

The option is designated by:

1.      Name of the associated stock

2.      Strike price

3.      Expiration date

4.      The premium paid for the option, plus brokers commission.

The two most popular types of options are Calls and Puts.