Chapter One

What Is an Option?

Options are simply legally binding agreements – contracts – between two

people to buy and sell stock at a fixed price over a given time period.

There are two types of options:

calls and puts. A call option gives the owner the

right, not the obligation, to

buy stock at a specific price over a given period of time.

In other words, it gives you the right to “call” the stock away from another person.

A put option, on the other hand, gives the owner the right, not the obligation, to

sell

stock at a specific price through an expiration date. It gives you the right to

“put” the stock back to the owner. Option buyers have rights to either buy stock

(with a call) or sell stock (with a put). That means it is the owner’s choice, or

option,

to do so, and that’s where these assets get their name.

Now you’re probably thinking that this is sounding complicated already. But

options are used under different names every day by different industries. For

instance, we are willing to bet that you’ve used something very similar to a call

option before. Take a look at the following coupon:

The way pizza coupons and call options work is very similar. This pizza coupon

gives the holder the right to buy one pizza. It is not an obligation. If you are in

possession of this coupon, you are not required to use it. It only represents a right

to buy. There is also a

fixed price of $10.00. No matter how high the price of pizzas

may rise, your purchase price is locked at $10.00 if you should decide to use it.

Last, there is a fixed time period, or

expiration date, for which the coupon is good.

Now let’s go back to our definition of a call option and recall that it

represents:

1) Right to buy stock

2) At a fixed price

3) Over a given time period

You can see the similarities between a call option and pizza coupon. If you

understand how a simple pizza coupon works, you can understand how call

options work.

Now let’s take a look at a put option from a different perspective. Put options

can be thought of as an insurance policy. Think about your car insurance, for

example. When you buy an auto insurance policy, you really hope that you will not

wreck your car and that the policy will “expire worthless.” However, if you should

total your car, you can always “put” it back to the insurance company in exchange

for cash. Put options allow the holder to “put” stock back (sell it) to someone else

in exchange for cash. Remember, if you buy a put option, you have the:

1) Right to sell stock

2) At a fixed price

3) Over a given time period

As you will discover, the mechanics of calls and puts are exactly the same; they

just work in the opposite direction. If you buy a

call, you have the right to buy

stock. If you buy a

put, you have the right to sell stock.

Option Sellers

We know that buyers of options have rights to either buy or sell. What

about sellers?

Option sellers have obligations. If you sell an option, it is also called

“writing” the option, which is much like insurance companies “write” policies.

Buyers have rights; sellers have obligations. Sellers have an obligation to fulfill

the contract if the buyer decides to use their option. It may sound like option

buyers get the better end of the deal since they are the ones who decide whether

or not to use the contract. It’s true that option buyers have a valuable right to

choose whether to buy or sell, but they must

pay for that right. So while sellers

incur obligations, they do get paid for their responsibility since nobody will

accept an obligation for nothing.

There are some traders who will tell you to always be the buyer of options while

others will tell you that you’re better off being the seller. Hopefully, you already see

that neither statement can always be true, because there are pros and cons to either

side. Buyers get the benefit of “calling the shots,” but the drawback is they must pay

for that benefit. Sellers get the benefit of collecting cash but they have a drawback

in that there are potential obligations to meet. What are the sellers’ obligations?

That’s easy to figure out once you understand the rights of the buyers. The seller’s

obligation is exactly the opposite of the buyer’s rights. For example, if a call buyer

has the

right to buy stock, the call seller must have the obligation to sell stock. If a

put buyer has the

right to sell stock, the put seller has the obligation to buy stock.

These obligations are really

potential obligations since the seller does not

know whether or not the buyer will use his option. For example, if you sell a

call option you

may have to sell shares of stock, which is different from saying

that you will definitely sell shares of stock. A call seller will definitely have to sell

shares of stock

if the call buyer decides to use his call option and buy shares of

stock. If you sell a put option, you

may have to buy shares of stock. A put seller

definitely must buy shares of stock

if the put buyer decides to use his put option

and sell shares of stock.

It’s important to understand that options only convey

rights to buy or sell

shares of stock. For example, if you own a call option, you do not get any of the

benefits that come with stock ownership such as dividends or voting privileges

(although you could acquire shares of stock by using your call option and thereby

get dividends or voting privileges). But by themselves, options convey nothing

other than an agreement between two people to buy and sell shares of stock.

Now that you have a basic understanding of call and put options, let’s add

some market terminology to our groundwork.