Options Are Easily Misunderstood, So What Are Options in Investing?
A term many new investors come across and find confusing is an option. We often get the question, “what are options in investing?” The answer is multi-tiered, so let’s start at the beginning.
An option is a binding, specifically worded contract that gives its owner the right to buy or sell an underlying asset at a specific price, on or before a certain date. The investor has the right—but not the obligation—to buy.
The right, but not the obligation, to take action is a key distinction. Upon the expiration date, you could always decide to take no action, at which point the option becomes worthless. If you make this decision, the option becomes worthless and you lose all of your investment, which is the money that you used to buy the option.
An option is only a contract that’s tied to an underlying asset (such as, say, a stock or stock market index). Hence, it is categorized as a “derivative,” because an option derives its value from something else. Derivatives have acquired a pejorative reputation of late, because incredibly complex derivatives helped fuel the financial calamities of 2008.
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What Are Options in Investing? More About Call and Put Options:
Options come in two flavors: call options (calls) and put options (puts).
If you think a certain asset will increase substantially before the option expires, you’d purchase a call option, because it gives you the right to buy an underlying asset at a specific price within a specific period of time.
If you think a stock will dramatically drop in value, you’d purchase a put, which would give you the right to sell the asset at a certain price within a specific period of time. Think of a put option as a form of leveraged short selling.
Accordingly, there are four types of players in options markets: buyers of calls; sellers of calls; buyers of puts; sellers of puts. The “strike price” is the price at which an underlying asset can be purchased or sold. For calls, this is the price at which an asset must rise above; for puts, it’s the price at which it must go below. These events must occur prior to the expiration date.
A “listed option” is traded on a nationwide options exchange, such as the Chicago Board Options Exchange (CBOE). These options are listed with fixed strike prices and expiration dates. The options are named based on their strike price and expiration date. For example, an ADSK January 45 Call is a call option on Autodesk stock at $45 per share that expires in January.
Call options are referred to as “in the money” if the share price is above the strike price. Put options are “in the money” when the share price is below the strike price.
So, what are options in investing? Is there more you’d like to know? Let us know in the comments.
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