Written by A.J. Brown

What Exactly Is an Option?

Call Option, Put OptionFirst off, if you submitted a question for me to answer, THANK YOU! This blog is about education, but it’s also a dialog. And the dialog doesn’t happen unless you leave comments and let me know what you’re thinking.

With that in mind, I want to address a fairly simple question: "What exactly is an option?"

I feel like it’s important for me to answer this question now since it seems we have a lot of new readers coming on board. Some of them are quite experienced, but some are just beginning to learn what option trading is about.

So let’s start at the beginning by defining what a stock is. A share of a stock represents part ownership in a company. If there are 100 shares of stock and you own 10, you then own 10% of that company. It helps to know what a stock is before we talk about options.

Okay, what is an option?

Simply this: an option is the right to buy or sell a stock (or commodity) at a certain pre-determined price. While this definition is helpful, it may not give you the understanding you need. So let’s dig deeper. (And for the sake of simplicity, I’m going to refer to stocks only, even though options can be traded on commodities and other securities as well.)

What is a call option?

A call option gives you the right to buy a stock at a certain price.

Let’s say the price of ABC stock is $50. But you think the price is going to $60. So you buy a call option that has a strike price of $55.

When you buy the option, it is "out of the money." That’s because your option can only be exercised if the price goes to $55. Right now, the price is still at $50.

But let’s say the price goes to $54. At this point, your option is very close to being "in the money." Because of this, the value of your option will have increased. You can resell the option for a profit, or wait to hit your strike price.

If your option does hit the strike price, you are now "in the money." Let’s say the price goes up to $58. You now have the right to BUY the stock at $55. You can then turn around immediately and sell that stock at the market for a profit of $3 on every share.

What is a put option?

A put option gives you the right to sell a stock at a certain price.

Put options are a little bit harder to understand because all the prices are working in reverse. When you buy a put option, you are expecting the price of the stock to decline. So here’s how it works.

Let’s say the price of XYZ stock is $50. But you think the price is going to $40. So you buy a call option that has a strike price of $45, which is below the current price of $50.

If the price of the stock goes down to $41, your put option is "in the money." You now have the right to SELL the stock for $45, your original strick price. Since the market price is $41, you buy it at that price, then turn around immediately and sell it for $45, making a profit of $4 on every share.

Who will pay you $45 for the stock? Naturally, the person who sold you the put option in the first place.

Summing up…

An option is the right to buy or sell a stock at a certain pre-determined price. A call option gives you the right to BUY at a certain price. You use a call option when you think the price of the underlying stock is going to go up. A put option gives you the right to SELL at a certain price. You use a put option when you think the price of the underlying stock is going to go down.

In reality, most options are never exercised. Most are bought and resold before ever hitting the strick price. This is because minor fluctuations in the price of the stock can have a major impact on the price of an option. So if the value of an option increases sufficiently, but still hasn’t hit the strike price, it often makes sense to resell it for a quick, safe profit instead of waiting longer and risking a total loss.

I hope this explanation gives you a better understanding of what options actually are. Leave a comment and let me know your thoughts.

Best regards always,

A.J. Brown

Categories: Education / Options

8 Responses to “What Exactly Is an Option?”

  1. VIKRAM SINGH JAIN @ 11:06 am:

    Excellent.Do you have a book on Options trading? Can you kindly send your article,7 Strategies Of Successful Options
    Traders: How to consistently trade options for
    BIG profits?
    Thank you.
    Vikram Singh Jain.02.05.08

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  2. A.J. Brown @ 1:10 am:

    Hey Vikram,

    My book is coming out late Spring / early Summer. In the meantime, I have an ebook you can pick up.

    http://www.tradingtrainer.com/ebook/

    And, if you’d like to listen to my “7 Strategies Of Successful Options Traders” audio course, you simply need to opt in at:

    http://www.tradingtrainer.com/

    The audio course will be delivered to your email address over the subsequent days after you opt in.

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  3. Francis OBrien @ 6:38 am:

    in the example above : xyz is going lower from 50. in the summary section you say buy call if it goes up . so why do i buy call at 45 if it is going down? why not buy put at 45 or lower to increase profit.

    when do you buy the put option to sell the stock at 41.

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  4. A.J. Brown @ 10:45 am:

    Francis - Actually, I gave two examples above. In one case, we are expecting the price to go up; in the other case, we are expecting the price to go down.

    I guess I didn’t make that totally clear since I used “XYZ” stock in both examples. I’ve changed one of the examples to say “ABC” stock to avoid confusion.

    You asked: “When do you buy the put option to sell the stock at 41?”

    Since this is only a hypothetical example, we’re not looking at when you should buy the put option. The illustration is only to explain what call options and put options are.

    Hope this helps.

    A.J. Brown

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  5. Bob Griffith @ 2:58 pm:

    Is there always a buyer for put options?, Same question
    for calls.

    Thank you

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  6. vijaya prasad @ 5:01 am:

    Dear Brown,

    Excellent.I am beginner in the financial domain and as i am searching for good stuff and i found your theory.
    I can say very Transparent explanation.

    regards
    vijaya prasad

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  7. Suresh Maharaj @ 12:34 pm:

    Thanks for the tutorial.
    It was done very simple allowing me to follow and understand the basics. Now I have a foundation to build on.

    Thanks again

    • 
  8. James cowans @ 12:08 pm:

    I would love to learn the ends and out of trading options

    • 

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