An option is a traded security that is a derivative product.
By derivative product we suggest that it is a product whose cost is centred on the price of another. Since we are referring to stocks, a stock option is centred around a number of factors, not least the price of the underlying stock.
There are also options on other traded securities such as currencies, indexes and interest rates, but here we will limit our discussion to stock options, or options based on stocks.
A essential characteristic about an option is that it decreases in value in the sense that it has a reducing lifespan, and has to be sold prior to its expiry date. As time goes by, the option loses value as it moves closer to its expiration date
When we speak of options in terms of volume, we refer to contracts. Every stock option contract is the same as 100 shares of stock. When we focus on 2 contracts, we are actually focussing on 200 shares, 10 contracts; and so on. For example focussing on 1,000 shares, 75 contracts 7500 shares and so on.
NOTE: It is important to understand the dollar cost of options before actually trading them. When an option is quoted at One Dollar.00 each contract, the speculator must remember that the $1.00 embodies a price of $1.00 every share, not every contract. Do not forget that each and every contract is valued at 100 shares. This implies that if you were to get one option contract valued at $1.00, your total cost will be $100.00 (1 contract x $1.00 each share x 100 shares each contract). If you were to get 10 contracts for $1.50 each contract, your whole cost works out at $1500.00. Adopt the principle below when evaluating the total dollar cost of the option.
Total Dollar Cost of Trade = Number of Contracts x Price per Contract x 100
Option contracts are literally a sales agreement between two parties. The 2 parties are the buyer (or holder) and the seller (or writer). When you buy an option contract you are considered to be long the option. When you sell an option contract, you are judged to be short the option. This presumes you had no prior stake in the said option.
In an option contract, although it looks like the buyer and seller should be combined together, they in actual fact are not. You see, the owner doesn’t actually buy from the original owner and the original owner doesn’t really sell to the new owner.
In fact, a group called the Options Clearing Corporation (OCC) jumps in the middle of the two sides. The OCC purchases from the seller and distributes to the new owner. This guarantees the OCC impartiality and, hence, means both the seller and the buyer can get out of a position without involving each other.
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