Generally speaking, options are used in many areas of business and investment. Employees of larger companies frequently get stock options as an incentive to stay with the company for a long time and help the company increase in value. A lot of real estate transactions involve the option to purchase additional neighboring acreage at a certain price within a certain number of years. And even leasing a car usually contains a “purchase option” at the end of the lease term.
So what is an option? In its simplest form, an option is an agreement that gives the holder of an option the right, but not the obligation, to buy (or sell) something at an agreed upon price by an agreed upon time. Sometimes, the holder or buyer of the option pays a fee to the seller in order to have this right.
Here is a simple, common example that should help. You and your spouse locate a perfect home that you’d love to buy. The only problem is the timing, as you won’t be in position to purchase the home for around six months. You and the seller agree to a price to purchase the home in the time period that you want – up to six months for now. For this seller concession, you agree to pay $2,000 (non-refundable if you chose not to buy) to the current homeowner. This contract gives you the option, but not an obligation, to buy that house at the agreed upon price at any time for the next 6 months.
In the investment world, the “house” in our example becomes a stock and is called the “underlying security.” The agreed upon price is called the “ strike priceThe price at which the option contract can be executed. ” and the end date of your agreement is called the “ expiration dateThe date that the option expires, usually the 3rd Friday of the month in the U.S..” The important factors are the agreement, the selling/buying price, the cost of the option, and any conditions to which the parties agree. To review, here is the real world option language verses and the investing option language:
|“Real World” language||Investor language|
|House:||Underlying Security (ie, Stock)|
|Buying price:||Strike price|
|Date agreement ends:||Expiration date or Expiry|
|Actually buying the house:||Exercising the option|
A key difference between this house example and stock options is leverage. Stock options allow investors to buy 100 shares of stock in a single option contract. For the rest of this chapter, remember that a single option contract covers 100 shares. So when we say an option is trading at $1.25, that means that option contract will actually cost $125.
As you will see, options can play a key and often times exciting role in your investment success. Let’s get started…