<-- Keywords: options basic, option trading, options trading -->
What is an Option?
An option is a traded security that is a derivative product.
By derivative product we mean that it is a product whose value
is based upon or derived from the price of something else. Since
we are talking about stocks, a stock option is based upon, among
other things, the price of the underlying stock.
There are also options on other traded securities such as
currencies, indexes and interest rates, but here we will limit
our discussion to stock options, or options based on stocks.
A distinguishing factor of an option is that is a depreciating
asset in the sense that it has a limited life, and has to be
used before the date on which it expires. As time goes by, the
option loses value as it moves closer to its expiration date
When we speak of options in terms of volume, we refer to
contracts. Each stock option contract is equivalent to 100
shares of stock. When we talk about two contracts, we are
talking about 200 shares, 10 contracts; we are talking about
1,000 shares, 75 contracts 7500 shares and so on.
Amount of Shares Equivalent Amount of Option Contracts
100 1
200 2
1000 10
7500 75
15000 150
50000 500
100000 1000
NOTE: It is important to understand the dollar cost of options
before actually trading them. When an option is quoted at $1.00
per contract, the investor must realize that the $1.00
represents a price of $1.00 per share, not per contract.
Remember that each contract is worth 100 shares. This means that
if you were to buy one option contract at a quoted price of
$1.00, your total cost will be $100.00 (1 contract x $1.00 per
share x 100 shares per contract). If you were to buy 10
contracts for $1.50 per contract, your total cost will be
$1500.00. Use the formula below when calculating total dollar
cost of the option.
Total Dollar Cost of Trade = Number of Contracts x Price per
Contract x 100
Option contracts are literally a sales agreement between two
parties. The two parties are the buyer (or holder) and the
seller (or writer). When you buy an option contract you are
considered to be long the option. When you sell an option
contract, you are considered to be short the option. This, of
course, is assuming you had no previous position in the said
option.
In an option contract, although it seems as though the buyer and
seller must be tied together, they are not. You see, the buyer
doesn’t really buy from the seller and the seller doesn’t really
sell to the buyer.
In reality, an organization called the OCC or Options Clearing
Corporation steps in between the two sides. The OCC buys from
the seller and sells to the buyer. This makes the OCC neutral,
and it allows both the buyer and the seller to trade out of a
position without involving the other party.
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