What is an Option?

Option Contracts In General

It helps to put this into context because the idea of an option can be a little bit confusing at first.  Options, in general, are born in contract law.  They are a paid for promise to keep an offer open for a specified period of time.  For example, if you wanted the “option” to buy a home, you could give them lets say $5,000 for the option contract.  That option contract would give you lets say 1 month to decide whether you actually want to buy the house before the offer expires.

For example, if you want the “option” to buy a home, you could give a seller lets say $1,000 for an option to purchase that home for $300,000.  That option contract would give you lets say three months to decide whether you actually want to buy the house before the offer expires.  During those three months, the value of the property could go up or down.  If something is discovered about the property within your three-month option window that drives the value of the property from $300,000 to $350,000 then you can still buy the property for $300,000.  On the other hand, if you discover that there are zoning restrictions or environmental issues below the land and the value drops to $40,000, then you are not bound to purchase the property at $300,000.  At the end of the three-month period, the offer is no longer enforceable, or in other words, it expires.  If you have not purchased the property within the window, your $1,000 dollars is gone, but that is significantly better than being bound to purchase a $40,000 property for $300,000.

Option Contracts in the Stock Market

Option contracts in the stock market follow the same concept.  Instead of the house as described above, you are buying a “stock” or “security.”  It helps to think of securities as a physical thing even though we do not actually receive the stock certificate in most circumstances.  The option contract here is a paid for promise to leave an offer open for the purchase of a security for a specific period of time.

Take this snapshot of apple for example.  Currently (or at the time of this post) AAPL is trading at $155.86.  This is the price that you would have the “option” to purchase Apple stock for.  If you purchase the option to buy 100 shares of Apple today for let’s say $10 and the exercise period is three months just like the house you could continue to purchase the stock at $155.86 for that entire three-month period.  This would be great if the stock went up to $170.00 because you would have the option to buy the 100 shares of Apple stock at $14.14 below market price.  That is a $14.14 profit per share, which times 100 shares is equal to $1,414.00 profit.

There is more terminology i.e. exercise price, strike price, puts, and calls but for now, I just wanted to get a general understanding of what an option is.  If anything is unclear about the general idea of stock options discussed above please leave a question and we will figure it out!