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What is an Option? Basic Option Terminology

What is an option? In the stock market there are a variety of financial instruments that sell not only stock, but ‘short or long’ positions based on expectations. Put Options are contracts between a writer (seller or issuer) and a holder (buyer or investor). The buyer purchase the right to sell a particular stock to the writer; the writer is obligated to sell at the put price but the buyer is not obligated to sell their put position. These types of contracts can include stock but will generally include commodities, oil, gold, etc., as well. Confused? Here are some examples to help.

If you’re a buyer you buy a Put. You think the price of a stock will decrease. You pay a premium which you will never get back. (This is where writer can make their money (also on the commissions)). You now have the right to sell the stock at strike price (your agreement at purchase).

If you’re the writer you may receive a premium, if buyer exercises the option, you must buy the stock at strike price, however, if the buyer does not exercise the option, you take profit from the premium.

An example with numbers:

You purchase a put contract to sell 10 shares of XYZ Inc. for 5. The current price is 5.5, and you pay a premium of .5. If the price of XYZ stock falls to 40 per share right before expiration, then I can exercise my put by buying 10 shares for 40, then selling it to a put writer for 50. Your total profit would equal 5 (50 from put writer – 40 for buying the stock – 5 for buying the put contract of 10 shares at .5 per share, excluding commissions).

But if the share price never drops below the strike price (in this case, 5), then you would not exercise the option. (Why sell a stock to someone at 5, the strike price, if it would cost you more than that to buy it?) Your option would be worthless and I would have lost my whole investment, the fee (premium) for the option contract, 50 (5 per share, 10 shares per contract). My total loss is limited to the cost of the put premium plus the sales commission to buy it.

More helpful pieces of info on put option terminology.

– The right – but not the obligation – to exercise in order to buy (call) or sell (put) an underlying security (bonds, stocks, futures).

– Contract for a period of time (time to expiry) at a particular price (strike price or exercise price)

– Contracts are standardized (always for 100 shares of stock) and trade until expiry date on teh exchange (secondary market) or OTC (over-the-counter)
– Must buy entire contract.

– The writer of an option is the issuer – total number of written contracts is the open interest.

– Contracts can be exercised by issuing an assignment notice.

Another Option Example With Interest Rates:

An investor believes interest rates are going to decline:

Two possible actions
1) Buy bonds outright or
2) Buy CALL options on bonds

Could buy a call on $1 Million of bonds for July delivery next year (exercise date) from a writer of the contract – investor pays a premium

If interest rates do go down the investor will exercise the right to acquire the bonds at the strike price (below the market price at that time) or just sell the option at a profit.

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