In it’s most basic form, an option is a contract between a buyer and seller for a specific item at a specific price by a specific date. A more formal definition can be found at Investopedia:
A financial derivative which represents a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).
Thus, the four parts of an option are the following:
- Item traded. Let’s use Level 3 Communications, LVLT, as an example
- Date the option expires
- Price agreed upon to purchase the item (in this case LVLT)
- A call or put option
In the stock market, options are defined in that order. I recently sold an option for LVLT with an agreed upon price of $5.00 that expires in Decemeber. Using the format above, the option would be described as LVLT Dec 5 Call. Simple huh? Those are the basics of reading an option.
Some key facts to know about options. First, options are sold in even numbered lots. What’s an even numbered lot? Any multiple of 100. In other words, one option controls 100 shares of a stock, without physically owning the stock. If you haven’t begun to realize just yet, that’s not a bad way to leverage with little capital. Therefore, if you were to purchase 3 options for LVLT Dec 5 Call, you would effectively control 300 shares of LVLT without physically owning it. This has its drawbacks of course. You can’t earn dividends on shares you don’t physically own, for example.
Next, options have a premium. Think of it as a fee for locking in the price of any kind of investment. Assume the fee to purchase the LVLT Dec 5 Call costs $1.00. Remember that options are sold in even numbered lots. Therefore, one option would cost $1.00 * 100 shares, or $100. 10 contracts of LVLT Dec 5 Call would cost you $1 * 100 * 10, or $1,000. This premium goes to the seller of the contract. Selling options will be discussed at a later date.
Lastly, dealing with options requires you to deal with time. The closer you are to your expiration date, the less time you have to cash your option out and make a profit. Time is always against the buyer’s side and as a result options don’t necessarily favor the buyer. Options expire on the third Saturday of the expiration month. This mean, for most of us regular investors, we must cash out our options the Friday before the third Saturday of the expiration month. If the option isn’t cashed out, or exercised, it becomes worthless and your premium paid for the option is lost.
There you have it. A basic description of options. There are multitude of strategies involving the purchasing and selling of options. I’ll try and go over the basics one by one from my perspective (as is of course the theme of this blog). However, there are quite a few references regarding options and options strategies. Check out the Investing Resources page for a list of references.
Disclaimer: I’m not a broker or a financial adviser. These are stocks I own or plan to own in the near future. Extensive research has been made on these stocks beforehand. You understand that the no content published on InvestingAdventures.com constitutes a recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.