What is an option: the contract and its two sides

First, the strange word: derivative

An option is a derivative. And that word, which sounds like jargon, is actually a fairly literal description: it means that its value is not its own. It is borrowed from the behavior of something else, and it goes up or down with it. That something else is called the underlying, and it is the first thing you need to learn to look at.

The underlying can be a stock, which is what we will use here; it can be an index, like the S&P 500; it can be a commodity — oil, gold — or a currency. The underlying mechanics are the same in every case: the contract goes up or down depending on what the thing underneath does.

Second: it is a contract, and a contract has two signatures

Here is the idea that holds everything else up. An option is nothing more and nothing less than a contract, and a contract, by definition, has two parties. Always. There are no options floating around on their own: if you buy one, it is because someone, on the other side, sold it. That someone exists, has a first and last name, and in part 2 we are going to sit in their chair.

Now, this contract has one peculiarity, and it is exactly the one you need to understand well: the two parties do not sign the same thing.

• The one who buys gets a right. They can exercise it or not, whichever suits them, until the expiration date. They decide.
• The one who sells takes on an obligation. They decide nothing. If the buyer exercises, they deliver.

One may; the other must. And since nobody agrees to be bound in exchange for nothing, the buyer pays the seller some money up front: the premium. That is the honest definition of the premium — the price of that asymmetry. It is what it costs to keep the other party tied down.

If a familiar image helps: it is just like a deposit to hold an apartment. You hand over some money and the owner commits to holding it for you at a price for a while; if you end up not buying, they keep the deposit. The asymmetry is the same — you decide, they are bound — and the deposit plays the role of the premium.

Third: the four facts that define the contract

We now know it is a contract between two parties and that its value derives from an underlying. What exactly does it say inside? Four facts. Only four. And we are going to fill them in with a real company so you can follow the numbers in your head: Verizon, the telecom company, trading around $47.

And now the detail that trips everyone up, no exaggeration: an option contract is not about one share, it is about a hundred. So that “$2” you see on screen is not $2: it is $200 leaving (or entering) an account. Multiply by a hundred before you decide anything.

One last note, and it is the one almost nobody puts in the examples: the broker charges. Let’s say $1.30 in commission per side — the buyer pays it and so does the seller. It is not much money, but in part 2 it is going to explain something important.

Four facts, and you have the whole contract. With that you can already read any options contract put in front of you. What the buyer is buying, what the seller commits to doing, how much it costs and how long it lasts. Nothing more, nothing less.

And why would I want to sign this?

You know how to read it. What is missing is the question that really matters, and that almost no tutorial asks early on: what does each side gain by getting into this? There are three reasons, and it is worth learning them in this order and not the reverse.

• Getting paid to commit to a price that already suited you. You sell the contract, collect the premium today, and in exchange you commit to buying (or selling) at a price you found reasonable anyway. If the market does not get there, you have kept the money for waiting. It is the most boring of the three, the one that shows up least online, and the one this series will spend the most time on.
• Protecting yourself from a drop that worries you. You own shares and do not want to sell them, but you do not want to eat an entire crash either. You pay a premium for the right to sell at a fixed price no matter what. It is insurance: you pay the policy hoping never to use it.
• Betting a small amount of money on a big move. You buy the contract and, if you are right by a wide margin and in time, you multiply what you put in. It is the one that makes the headlines, the one that hooks everyone who discovers options… and the one that works out least often, for reasons you will see with numbers in part 2.

All three use exactly the same contract you have just learned to read. The only thing that changes is which side you take and why. And notice something: the first two are signed by someone who already had a plan for that stock; the third is signed by someone who wants something to happen. That difference in temperament explains a good part of who makes money with this and who does not. The first one is boring, and that is why it works.

What is worth remembering

If you only take three ideas from this first part, make them these:

• An option is a derivative: its value is not its own, it comes from the underlying. You buy a contract that depends on the stock, not the stock.
• It is a contract between two parties. The buyer has a right and decides; the seller has an obligation and complies. The premium is the price of that difference.
• It is defined by four facts — underlying, strike, expiration and premium — and it always covers 100 shares. Multiply by a hundred before you decide anything.

Next stop: you now know what gets signed, but not what happens when the date arrives. In part 2 we follow this same contract to its last day and do the math for both sides — which add up to exactly the same thing, and that is where the lesson is.

Keep reading

• Calls and puts: the only four scenarios there areBuy or sell, call or put: four positions and nothing else. Who pays, who is obligated, and the two you will actually use.