I like the definition of Option as per “Merriam-Webster”.
“Option is the Opportunity or an ability to choose something.”
Any understanding of Options in the context of Financial Instruments should begin with this. This makes Stock Options easy to understand and relate to. I will try and explain Options in the context of Stocks as its easy to relate to. The moment we add buzzwords such as financial derivatives and financial instruments, things start getting harder and difficult to understand. So, I will keep it simple. Here we go.
For those who do not understand stock, I would refer you to quickly read through or google it as its the most fundamental of things that you would need to know if you want to get into investing.
At a summary level, stock provides ownership of a company. It’s the most basic investment/financial term everyone is familiar with. For example, if you are buying a Tesla stock, you are buying part ownership of the company.
And when I talk about Stock Options, I am talking about choices/options around stocks of a company. When you buy a stock such as TSLA (Tesla), you buy it by paying the price at that point of time called the Market Price of the stock. The reason I bring this up is because you are buying or selling the stock at a point of time; And price fluctuates based on supply and demand and varies by time.
In essence, its similar to going to a market and buying a piece of art which you can sell off to someone else, if you would want to, at a higher price later if the value of the art goes up in the eyes of the buyer (profit) or at a lower price if the demand is lower.
Note: I am relating the conversation to stocks so that it’s easier for you to understand options in the context of stocks.
In case of stocks, there are two main parties involved – a buyer and a seller.
A buyer buys a stock from a seller. Or I could say the same thing as “A seller sells a stock to a buyer”.
In this case, a transaction of buying or selling is involved between 2 parties at a point of time at a particular price. (I am not bringing in the concepts of commissions and broker fees into the mix to keep it simple.)
As the universe is large, these transactions can happen between multiple parties; buyer A can sell to buyer B who can sell to buyer C and so on..There are so many permutations and combinations possible as people in this world 🙂
In summary, what we have seen is that a “point of time” and a “price point” is involved during the process of buying and selling of a stock.
This brings us to the concept of a Stock Option.
A stock option gives you the “Opportunity or an ability to choose” to either buy or sell a stock at a point of time at a particular price. Just pay attention to the words I have used in explaining stock options.
When you buy a stock, you are buying the stock itself similar to buying an art and owning it. When you are buying a stock option, you are not buying the stock but buying the ability to choose an action on the stock to either buy or sell the stock at a future time.
In case of options, just as in stocks, a buyer and a seller is involved in the transaction which is a form of a contract.
If you notice, the transaction of buying and selling a stock involves transfer of money from buyer to seller at the price at that point of time (market price) which becomes the sale price.
In case of an option, buying and selling the option also involves transfer of money. This money is paid by the buyer to the seller to earn the right to choose an option to act on a stock to either buy it or sell it in future. This amount is called the “Premium” which is different from the “Sale Price of the Stock”. You can say, premium is the sale price of the Option.
So what does paying a premium allow you to do? In case of a stock paying a sale price allowed you to own the stock with an ability to sell it in the future (if there is demand). In case of an option, paying a premium allows you a flexibility to buy or sell a stock if you so choose at a point of time in the future. You see here, there are so many variables that have come in play.
In this article we discussed
The variables at play in Options are:
1. Ability to choose a decision to either a. buy a stock or b. sell a stock (this is called exercising the option)
2. Ability to forego that choice. (this is option expiry, i.e option gets expired unexercised
If you look at these transactions closely, what you will find is that in case of stock sale transaction there is buying or selling of a stock.
In case of an option sale transaction, there is buying and selling of an option. Here, I have brought in the concept of selling of an option which is where things get tricky. Selling a stock is simple – stock changes hand from buyer to seller.
But what exactly is selling an option. Think of this in the context of the definition of buying an option – an ability to choose a decision. The opposite transaction to being able to make a choice is “foregoing the choice to make a decision”.
Note: One thing to note when I am using the term buyer and seller is the fact that buying and selling is happening over a marketplace where exchange is happening between various parties. So, in essence its not 1 buyer and 1 seller but transactions happenings all the time with someone buying and someone selling managed by the stock exchange through the broker. So, there is a system in place to connect various parties using algorithms all the time
I have summarized what I have talked about in a summary table. Hope this is easy to understand for the readers. Happy for you to write to me at firstname.lastname@example.org with your ideas and suggestions.
|Buying a Stock||Buying an Option|
|Means buying a stock 🙂||Means buying an option to either buy or sell the stock|
|Involves a buyer and a seller||Involves a buyer and a seller|
|Buyer owns the stock after purchase||Buyer owns the option after purchase. |
Buyer doesn’t own the stock on purchase of an option.
|Transfer of money happens once – while buying or selling a stock||Transfer of money can happen twice. |
1. Once while buying or selling the option
2. And when the actual stock changes hands if the option is used.
Options are choices and I would love to make it easier for you to exercise those choices. – Santo