What Are Options?

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Options are a fast-paced and complicated investment. Photo: Spencer Platt/Getty Images

Definition: An option is a derivative that gives the owner the right to buy or sell securities at an agreed upon price within a certain period of time. Here's what all these terms mean:

Option: You pay for the option, or right, to make the transaction you want. You are under no obligation to do so.

Derivative: The option derives its value from that of the underlying stock. This underlying value is one of the determinants of the option's price.

 

Agreed-upon price: This is known as the strike price, and it doesn't change over time, no matter what happens to the stock price. It has that name because you will presumably only strike when the underlying value will make you money.

Certain period of time: That's the time until the agreed-upon date, known as the expiration date. That's when your option expires. You can exercise your option at the strike price on anytime until the expiration date. In Europe, you can only exercise it exactly on the expiration date.

There's three other components that determine the price of the option. First, is implied volatility. If traders think the price of the underlying asset will swing wildly, therefore be more volatile, it will drive the option price higher. Second, is dividends. If they are paid by the underlying stock, it will drive the options price up slightly. Third, is interest-rates. Here again, if they are high it will drive the options price up a bit because bonds are competing with options for the investment.

 

Two Major Types of Options

Hedge funds and other traders use options to buy and sell stock or commodities without ever actually owning any.

The right to buy is called a Call Option or a call. A call option is "in the money" when the strike price is below the underlying stock value. That means, if you bought the option and sold the stock today, you'd make money.

Many people advocate using call options as a low-risk way to invest in stocks. That's because you can only lose the cost of the option itself, which is usually much lower than the strike price or underlying value. However, the time until expiration is the big risk. That's because you are basically betting that the stock will do what you want on schedule. That's called timing the market, and it's pretty much impossible. 

With a Put Option, or simply a put, you purchase the right to sell your stock at the strike price anytime until the expiration day.In other words, you have purchased the option to sell it. A put option is "in the money" when the strike price is above the underlying stock value.That means, if you bought the option to sell, and bought the stock today, you'd make money because your purchase price was lower than your sale price.

Weeklies

Most option contracts are for a month or more. However, contracts that are only for a week have become more and more popular since the Chicago Board Options Exchange created them in 2005. There are more than 400 types of contracts available on stocks like Apple and Facebook, indices like the Russell 2000, and exchange-traded funds like United States Oil.

 

Hedge funds and other traders buy them to wager on short-term events. Others sell them to raise cash, collecting $500,000 each week in premiums. As long as they are on the right side of the trade, it won't affect the market. However, in a crisis, they could increase volatility of a stock by being forced to purchase millions of shares to cover the options. (Source: Steven M. Sears, "Strong Weeklys in a Weak Market," Barron's, April 217, 2015.)

Also Known As: stock options, Futures Options