Options ABC

Chapter 1: What are options?

Have you ever asked the questions like the following?

  • I bought an insurance contract for my car. Can I have one for my stocks?
  • The stock prices remain stagnant for quite some time, what could be done to improve my returns?
  • It is too expensive to buy a board lot of the stock, is there any other means to minimize my upfront cost?

The answer is simply OPTIONS. Never heard of that? No worries, you will figure out how to achieve these goals after completing this Options ABC section.

An option is a contract for the right to determine whether to enforce a purchase/sales agreement for an underlying asset (stock/index).

The option buyer pays premium to the seller and acquires the right i.e. to decide whether to buy or sell the underlying asset (stock/index) at the agreed price before the option contract expires.

On the other hand, the option seller receives the premium and grants the right to the buyer i.e. he is in a passive position - he will have to perform the agreement to buy or sell the underlying asset (stock/index) if so requested by the buyer before the option contract expires.

Confused? Let's think in this way. Imagine a store that sells something to the mass public and has plans to sell a new product, say a new watch on 9th November 2012. Nobody knows how much the new watch is going to cost yet.

Today is 8th October 2012. The store is selling coupons for $5 (in this case the premium) that would give the holder of the coupon the right to purchase the watch for a fixed price at $100 before 30th December 2012.

You want to buy the new watch and hence you bought the coupon.

When the time comes to sell the new watch, if the store sells it for $150, you will use the coupon (i.e. exercise the option) to buy the watch at $100. The watch costs you a total of $(5 + 100) = $105, which is still $45 cheaper than the listed price.

But what if the store sets the watch price below $100, say $90?

You will not use the coupon to buy the watch because you can buy it at a lower price. However the $5 paid on the coupon is still part of the costs to buy the watch.

The total cost to buy the watch is now $(5 + 90) = $95, which is still cheaper than buying the watch by using the coupon, i.e. $(5 + 100) = $105.

From this example, you can see that you have an option to decide whether to buy the watch at pre-defined price or not. You may pay a bit more to buy the watch but you know the maximum costThe maximum cost is the price you paid for the coupon plus the fixed price to buy the watch, i.e. premium paid on the option plus the strike price to buy the underlying asset.. This is a simple analogy as options.