What is an Option? - Print Friendly Version

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What is an Option?

First things first, what is an option? In a nutshell, an option is a contract that gives the holder the right, but not the obligation to buy or sell shares of the underlying security at a specified price on or before a given date. If that sounds like something your family lawyer might have written don't fret, we promise it is really very simple – and you won't have to worry about that surprise bill in the mail.

Despite what you might hear, there are only two types of options, calls and puts. A call option gives its holder of the contract the right to buy an underlying security, whereas a put option gives the holder the right to sell an underlying security at a given price on or before a given date. Simple enough so far, right? --let's make things even more clear.

Consider this example, International Business Machines (IBM) is trading at $100. One American-style IBM Corp. November 80 call sells for $2 and entitles the holder to purchase 100 shares of IBM Corp. common stock at $100 per share at any time prior to the option's expiration date in November. Similarly, one American-style IBM Corp. November 100 put sells for $2 and would entitle the holder to sell 100 shares of IBM Corp. common stock at $100 per share at any time prior to the option's expiration in November.

In our example the option style is American (more on that later), the underlying security is IBM Corp., the strike price is 100, the expiration date is November, the unit of trade is 100 shares and the option premium is $2. All of these components are defined by the option contract. To understand options, it is important that you understand the contract, what it implies and the significance of each component.

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