An option is a type of derivatives contract. It’s called derivative because the value of the option is derived from the performance of another asset. That asset is called the underlying asset and it can be any of the following financial instruments – stocks, futures, commodities, or currencies. We’ll focus on stock options.

In a stock option contract, the underlying asset is the stock that the option contract can be used to purchase or sell. The option contract gives a buyer (the owner) the right but not the obligation, to buy or sell an underlying asset (stock) at a specified price (called the strike price) on or before an agreed to date (called the expiration). The seller has an obligation to complete the transaction – to sell or buy the stock if the buyer exercises the option. The buyer pays a premium to the seller for this right by buying a stock option. Exercising the option simply means that the buyer wants the contract to be in force.

An easy way to understand the concept of option contracts is to think about buying a house. Let’s say you found the house of your dreams but you don’t have the cash to buy it today. The seller is listing the house for $250,000 and you know you’ll have the money in three months. So, to protect the house from anyone else buying it, you create an option contract with the seller. Your contract would state three things:

  • The strike price of the underlying asset (the agreed to price of $250,000 for the house)
  • The expiration date of the contract (three months from today’s date)
  • The premium amount you’ll pay to the seller for the contract to be in place

So you sign the contract and give the seller the $3,000 premium you agreed to. Now during the three months many things can happen. The house (the asset you are protecting) can increase in value based on improvements by other homeowners in the neighbourhood and now it’s worth $400,000. Or, there could be no change in the value of the house. Or, the house could decrease in value because a gas station opened up next door and now the value of the house is only $175,000.

At the expiration date of the option contract you have a decision to make based on three scenarios.

Scenario 1 – The underlying asset (house) value increased from $250,000 to $400,000. Because you had an option contract in place, the seller is obligated to sell you the house at the original agreed to price of $250,000 even though it has increased in value. Since you want the house, this is an excellent deal – the option contract has worked in your favour, but not the seller’s favour. The increase in value could have been much less, say $300,000 but you can still purchase the house if you want for $250,000 (plus $3,000 for the premium to purchase the option contract) because that’s what you agreed to in the option contract.

Scenario 2 – The underlying asset (house) value remains the same at $250,000. If there is no change in the value of the asset, then you can decide if you still want to buy the house for the original agreed to price of $250,000 (plus $3,000 for the premium to purchase the option contract). Both you and the seller are happy.

Scenario 3 – The underlying asset (house) value decreased from $250,000 to $175,000. You have a right, but not an obligation, to purchase the house. If you decided you still wanted the house you would have to pay $250,000 even though you know its value is $175,000 because that’s what you agreed to. However, you don’t have to buy the house. You can consider the $3,000 premium you paid to be a small price to pay versus buying an asset for more than it’s worth.

How do options work?

Options can be bought and sold on several North American public options exchanges. The Chicago Board Options Exchange is the largest. You are simply buying the right (option) to buy or sell an underlying asset (stock) for a set price (strike price) by an expiry date. You pay a premium to the seller to protect the asset until the expiry date. You have the right, but not the obligation, to buy the stocks. The seller however must honour the expiry price by selling the option for the underlying asset at the strike price if the buyer decides to exercise the option. There are a variety of strategies designed to manage risk, minimize loss, and make a profit. But before you read through the strategies, there are some option terms you need to understand.