If you are new to options trading, some of the terms you'll hear more experienced traders throwing around can be very confusing.
I'm going to help you wade through the confusion by going through some of the basic fundamentals of options trading, and then getting into more advanced strategies.
Before I go any farther, I'd like to say that I'm going to be specifically talking about options where the underlying asset is stock. This is the most common scenario, although there can be options on many assets including other financial instruments, real estate, commodities, crude oil, etc.
With that stated, one of the first things to understand is that there are 2 basics types of options; calls and puts.
Let take a look at what a put option is and how we can use them to our advantage...
I'm going to help you wade through the confusion by going through some of the basic fundamentals of options trading, and then getting into more advanced strategies.
Before I go any farther, I'd like to say that I'm going to be specifically talking about options where the underlying asset is stock. This is the most common scenario, although there can be options on many assets including other financial instruments, real estate, commodities, crude oil, etc.
With that stated, one of the first things to understand is that there are 2 basics types of options; calls and puts.
Let take a look at what a put option is and how we can use them to our advantage...
What is a put option?
A put option is a financial contract between two parties, the seller (or writer) and the buyer (or holder).
The buyer of the contract is paying the seller a fee (referred to as the premium) for the right, but not the obligation, to sell the underlying asset to the writer within a certain period of time at a predetermined price, known as the strike price.
The seller of the contract has the obligation to buy the underlying asset at the strike price if the buyer chooses to exercise the option. In exchange for this obligation, he is collecting a premium from the buyer of the put option contract.
In English please!?!?
Let's see if I can say it more simply...
If you buy a put option: You pay some money upfront, and you have the right to sell your stock at a certain price, no matter how much the stock declines. If you don't want to sell the stock, you can keep it and let the contract expire worthless.
If you sell a put option: You make some cash as soon as someone buys it, but if the buyer decides to exercise the option, you have to buy his stock for the price stated in the contract, regardless of the actual price of the stock. This means that if the stock price falls, you might have to pay more than it's currently worth at the time.
The buyer of the contract is paying the seller a fee (referred to as the premium) for the right, but not the obligation, to sell the underlying asset to the writer within a certain period of time at a predetermined price, known as the strike price.
The seller of the contract has the obligation to buy the underlying asset at the strike price if the buyer chooses to exercise the option. In exchange for this obligation, he is collecting a premium from the buyer of the put option contract.
In English please!?!?
Let's see if I can say it more simply...
If you buy a put option: You pay some money upfront, and you have the right to sell your stock at a certain price, no matter how much the stock declines. If you don't want to sell the stock, you can keep it and let the contract expire worthless.
If you sell a put option: You make some cash as soon as someone buys it, but if the buyer decides to exercise the option, you have to buy his stock for the price stated in the contract, regardless of the actual price of the stock. This means that if the stock price falls, you might have to pay more than it's currently worth at the time.
Why would I want to buy a put option?
Put options are usually purchased as protection against falling stock prices. You can think of it as a sort of insurance policy: you pay the premium upfront so that if the underlying stock falls below the strike price, your potential loss is limited.
Why would I want to sell a put option?
Simply put (pun intended!), puts are generally sold to collect the premium.
The seller of the contract believes that the price of the underlying stock will remain at or above the strike price, and therefore the buyer will not decide to exercise the option and it will expire worthless.
The seller of the contract believes that the price of the underlying stock will remain at or above the strike price, and therefore the buyer will not decide to exercise the option and it will expire worthless.
Quick Jargon Reference Guide
Definitions of some of the terms used when describing put options.
Put Option: A financial contract between 2 parties concerning the right to sell an underlying asset.
Seller (Writer): The person writing and selling the contract. Must purchase the underlying asset if the buyer exercises the option.
Buyer (Holder): The person paying a premium to the seller of the contract in exchange for the right to sell the underlying asset.
Premium: The priced payed for the option contract itself.
Strike Price: The predetermined price stated in the contract at which the underlying asset will be sold, if the holder exercises the option.
Exercise: To exercise a put option is for the holder of the contract to utilize his right to sell the underlying asset, obligating the writer to purchase it.
Expire: All options have an expiration date. If the holder does not exercise the option, it will expire worthless.
Underlying Asset: The "thing" which will be bought or sold if the option is exercised. Most often stock, but can be many things.
Seller (Writer): The person writing and selling the contract. Must purchase the underlying asset if the buyer exercises the option.
Buyer (Holder): The person paying a premium to the seller of the contract in exchange for the right to sell the underlying asset.
Premium: The priced payed for the option contract itself.
Strike Price: The predetermined price stated in the contract at which the underlying asset will be sold, if the holder exercises the option.
Exercise: To exercise a put option is for the holder of the contract to utilize his right to sell the underlying asset, obligating the writer to purchase it.
Expire: All options have an expiration date. If the holder does not exercise the option, it will expire worthless.
Underlying Asset: The "thing" which will be bought or sold if the option is exercised. Most often stock, but can be many things.
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Was this information helpful? Not helpful? Was I incorrect about something? Just want to say hi? Whatever the case may be, I encourage you to leave some feedback!
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Robert
Mar 25, 2012 @ 10:12 pm | delete
- This was the only clear explanation I could find.on the net. THANK YOU
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Jason
Oct 25, 2010 @ 1:09 pm | delete
- Makes sense - thank you
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Mike
Nov 23, 2009 @ 5:11 pm | delete
- Not too terribly helpful. Need to have exapmles.
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LM
Oct 20, 2009 @ 3:26 pm | delete
- can anyone give an example of an entire transaction?
Symbol used, stock price at the time, fees and gain or loss
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Darren
Oct 18, 2009 @ 12:25 am | delete
- who issues most of the options, brokers? So does that mean if there have been a lot of contracts bought at a particular strike price and the stock is falling, the broker who may also be holding the stock, has a double invested interest in holding the stock price up as it nears the strike price?
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by optiontradingmentor
I am an options trader who is trying to make the subject easy to understand and accessible by everyone.
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