Options are a poorly understood and complex investment tool. There are two types of options – a put and a call. A call option is an option to buy something at a specified price. The price is called the exercise or strike price. A put option is the right to sell something at the specified exercise price. They go back in history thousands of years. They have been used to buy land, for example, at a future date. Someone would pay for the option to buy at a future date.
American and European options are the two types. These do not refer to geography. Rather they refer to when you can exercise an option. The American option can be exercised on any date before the exercise date. The European ones can only be exercised on the exercise date.
Stock options are usually to right to buy or sell 100 shares of stock. You are buying an option to buy a stock. It costs more money to buy the stock outright than it does to buy an option. Options are also called derivatives because it is essentially a small part of the larger thing that you want to buy or sell. For example, a single option can control the sale or purchase of a large block of stock. Thus the option is a derivative of the block.
The first exchange was the Chicago Board Options Exchange (CBOE) which started in 1973. Before the CBOE, options trading was done only through brokers and didn’t have the popularity that it does today.
One of the more complex things about options is the relationship between the option price and the stock price. For call options (the right to buy a stock), if the stock price is less than the exercise price, the option is worthless. You are not going to pay more for a stock if you buy an option that if you can buy the stock on the market. The option is called “out of the money” (or when the stock price is less than the exercise price). When the stock price is greater than the exercise price the option is “in the money.” If you want to make money on the option you should always exercise the option on the expiration date if it is in the money (otherwise you are losing money). A put option functions in the reverse manner as a call (for whether it’s in the money or out of the money).
Put-call parity is an important concept in options. The stock price should equal the call price minus the put price plus the exercise price on the day that the option expires (the exercise date). It is also necessary to add in the present discounted value of any dividends paid by the stock. Furthermore, this concept should hold on all dates because if it didn’t there would be an arbitrage or profit opportunity. The prices may not be exact because of transaction or trading costs.
