WHAT IS AN OPTION?
An option is simply this...
A contract between two counterparties to exchange an underlying (such as 100oz of gold) at an agreed price and at an agreed date in the future. HOWEVER, one counterparty buys the option (pays a "premium") to have the OPTION to walk away from the deal.
Here are two simple examples:
Sam is selling his house for $500,000. John wants to buy the house from Sam, however, he is not sure if real-estate prices will continue to appreciate. So, he pays the owner of the house $5000 to hold it for him for six months. If John changes his mind he losses the $5000. This is an option contract.
John paid $5000 for the option to buy the house for $500,000 within 6 months time (lets say by December 1st). This $5000 is NOT a deposit and cannot be used towards the purchase of the house. Remember, Sam has costs during those 6 months and is taking the risk should the housing market collapse - therefore, Sam pockets the $5000 regardless if John buys or not.
Therefore, John's break-even on the deal is $505,000 ($500,000 + $5000). The house needs to be worth more than that for him to exercise his option and buy the home.
Let's pretend that the house skyrocketed and was worth $700,000 6 months later. Would John exercise his option to buy it for $500,000? Absolutely. What would his gain be?
$700,000 - $500,000 - $5000 = $195,000
What if it was worth only $400,000? Would he excersise his option to buy it for $500,000? Absolutely not! What would be his loss?
$5000
TERMINOLOGY USED IN OPTION TRADING
In option trading we use certain terminology. All option contracts have these attributes:
- An underlying (in this example a house)
- Strike price
- Expiration date
- Premium
- A buyer and a seller of the contract (seller also known as the writer)
- All options are either CALL Options (the option to buy) or PUT Options (the option to sell)
Let's look at the above example and define the terms.
JOHN |
SAM |
John wants the option to buy the house, therefore, he is the buyer of an option to buy.
Buyer is known as: the buyer
Options to buy is know as a: CALL OPTION
|
Sam sells John the option contract and collects $5000. He is therefore the seller of the option to buy
Seller of an option is known as: the seller or writer
The $5000 he collects is known as: the premium |
As John is the buyer of the contract his risk is limited to the premium he paid. John's risk is LIMITED to $5000.
*If this was an exchange traded product John would have no margin requirements. |
Sam's risk is UNLIMITED since the house could be worth $10,000,000 and he still only gets $500,000 + the premium.
*If this was an exchange traded product Sam would have to post margin. |
Contract comes due on December 1st. This is known as: the expiration date |
The agreed to price is $500,000. This is known as: the strike price |
What the option is based on, in this case a house, is known as: the underlying |
WANT TO LEARN MORE? TAKE A LOOK AT OUR OPTION COURSES!
* Some information is compiled from public sources and believed to be reliable but is not guaranteed as to its accuracy or completeness. No responsibility is assumed for the use of this material and no express or implied warranties are made. Nothing contained herein shall be construed as an offer to buy/sell, or as a solicitation to buy/sell, any security, commodity or derivatives instrument. Instruments such as Futures, Forex, Options, and CFD trading involve a substantial risk of loss and is not suitable for all investors. Please carefully consider your financial condition prior to making any investments.
