This is the first part of a three-part series about the basics of the options market. In this article, we’ll go over the basics of how options work, the parties involved, and some real-life examples.
An option is a contract between two parties that gives the holder the right, not the obligation, to buy or sell an asset at a specified price, for a given period of time. The writer (seller) of the option has the obligation to allow the buyer to exercise the option at any time during the contract period. For this reason, the writer must keep the asset available for the buyer during the contract period.
The Parties of an Options Contract
The holder of the option is the one who is buying the rights outlined in the contract. They can be buying the right to buy or sell an asset at a specified price. In the next paragraph, I outline an example of holding an options contract to buy or sell a car. In both examples, I am the option holder.
The holder pays a premium and has no obligation to exercise the contract.
The writer is the party who is selling the rights outlined in the contract. In exchange, they are paid a premium by the holder.
The writer receives a premium and has an obligation to perform on the contract if the holder exercises it.
Real-Life Examples of an Option Contract
Let’s use an example. Perhaps I’m driving an old, unreliable car at the moment and I’m afraid it might break down any day. For this reason, I might want to buy your Toyota Camry in the next year. You and I come to an option agreement that gives me the right to buy your Camry at any time in the next 12 months for $3,000. I pay you $500 for this right.
You get to keep the $500 whether or not I exercise the option, this is known as the premium paid by the holder. Options are similar to insurance, in that the policyholder pays the underwriter a premium for the protection provided.
I’m the only person you can sell the Camry to in the next 12 months. I can let the option expire without purchasing it because there’s no obligation for me to buy the car.
The Camry might appreciate in value to, let’s say $4,000, during the contract period. That would put me at a $500 profit.
Current market value: $4,000
Strike price of Camry: $3,000
Price of buying option: $500
Put simplest, a call option gives the holder the right to buy an asset, while a put option gives the holder the right to sell an asset.
The Camry example above is an example of a call option.
Perhaps I own a piece of expensive real estate in the Hamptons area. After some analysis, I come to the conclusion that the Hamptons real estate market might be heavily affected by an upcoming recession.
In this example I don’t want to sell my house, I want to continue living there, but I don’t want to lose a bunch of money on it. This is a perfect situation to come to an option agreement with someone who holds the opposite view. A put option.
Let’s say I found John, who is bullish on the Hamptons real estate market and wants to use an option to speculate on it. We come to an agreement that gives me the right to sell my house to him at $1,000,000 for the next three years. For this right, I pay him $30,000.
Whether or not I exercise the option, John gets to keep the $30,000.
If at any time in the next three years, I have decided to exercise the option, John has the obligation to buy the house for $1,000,000, regardless of the current market value.
If the market doesn’t drop or goes up, I don’t have to exercise the option.
In summary, an option is an agreement between the two parties. The holder pays a premium for the right, not the obligation, to buy or sell an asset for a specified price, and the writer receives a premium for the promise to buy or sell an asset for a specified price.
In the next part of the series, we’re going over the purpose of options, and the several ways to profit from them.