Over the past few years, options trading have become more mainstream with many discount brokers advertising options trading along with other investments such as mutual funds, stocks and bonds. There are even online discount brokers with the word “options” in their names — e.g., OptionsXpress and OptionsHouse. But what exactly are options? An option is a contract that gives you (the buyer) the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. Since an option is a contract that deals with an underlying asset, options are called derivatives — which means it derives its value from something else.
Let’s take a look at an example. Assume you’re in the process of buying a business but need time to evaluate what you’re buying. To make sure you don’t lose out on the opportunity to buy this business, you negotiate with the owner for the right to buy his business for $500,000 any time during the next 3 months. The owner agrees, but asked you to pay $5,000 for this right.
Now we can consider two possible outcomes:
There are a few important things to take away from this example.
A call is the type of option described above. It gives you the right to buy an asset at a certain price within a specific timeframe. When you buy calls, you’re hoping that the price of the underlying asset will go up before the option expires. A call can also be used to hedge your short position against a short-term price increase.
A put gives you the right to sell an asset at a certain price within a specific period of time. This is similar to short selling a stock where you hope the price will fall before the option expires. A put can also be used to hedge your long position against a short-term price decline.
That’s the basics of options, puts, and calls. However, you should realize that this is a very complex instrument and should not be taken lightly. In the future, I hope to go deeper into various aspects of options trading as well as provide you with a list of discount brokers that are catered to options trading.