Option – The Concept of Balance
Say the word “option” to many non-institutional financial investors and they quickly lose interest in the topic. The reason they lose interest is because options in the financial world seem to be equated with gambling or high risk. Yet options can play an important role in balanced stock portfolios, so ignoring this investment should not be an…well…option.
Ignoring the play on words, the definition of an option is: a right without an obligation to an underlying futures contract at a particular price and at a particular time. Of course, the definition can raise a number of questions. For example, what does it mean to have “a right without an obligation” and what is an “underlying futures contract” and how is the price set and how much time is allowed?
These kinds of questions are typical when first learning option basics. They are typical and important questions because you don’t want to get involved in options trading unless you understand the concept and the financial terms.
You Have the Right to Exercise…Your Options
The fact is you have the right to an option that is actually a legal right to buy or sell a contract that has an underlying equity or commodity giving it value now and at some point in the future. Equities are usually stocks but not always. You can also buy options on future contracts with a commodity as the underlying asset like corn for example. But people who invest in commodity futures are normally major players in the marketplace because of the size of the investment required. Of course, if you decide to buy the futures contract, you are not actually going to find yourself owning trucks full of corn. That’s because you are buying a contract and not the asset.
Options that are exchange traded, like stocks and commodities, are agreements to buy or sell contracts according to prearranged terms. Those terms include the future price you are willing to buy or sell at and the time limit for deciding if you want to exercise the option. Other terms that are established before the transaction takes place include the quantity of the equity to be optioned and the way the equities will be delivered in the event the option is exercised.
The options transaction takes place in an exchange which is why they are called exchanged traded transaction. You may decide for example, to buy an option on 100 shares of XYZ stock at $5.00 a share within 30 days. This is a futures contract and the underlying equity is the stock. You can buy multiple options and each option normally covers a 100 shares. The $5.00 is called the strike price which is the price at which the option can be exercised.
The definition also states that the option can be exercised at some point in the future. This future date actually represents the date on which the option expires. If your futures contract said you could buy XYZ stock at $5.00 a share in 30 days, you can’t decide on the 31st day to exercise your right. On the 31st day the option has expired. But you can exercise your right anytime from the 1st to the 30th day.
In the Future
Options deal with the future. When you trade in options, you are trading contracts that have an underlying equity and the trading can take place in the future based on a specified price. Underlying equities may be stocks, currencies, silver or gold, corn, soybeans or anything else that can bought and sold. The option is saying that you have a right to purchase or sell a contract based on the current value or a value projected for the future.
Are their risks involved in this type of investment? Naturally there are risks, but you can minimize those risks by making sure you understand what an option is and how it works in the marketplace. Like any investment, the more information you have, the better investment decisions you can make.
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Filed under All About Options by on Aug 17th, 2010. 
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