Understanding Options For Newbs Part Ia: What is an option?

In the last post I discussed what an option is most in terms of money. But you should also know where these options are coming from, because when you buy an option someone else must be selling that option to you. When you hear about CEOs getting millions of dineros in stock options, these are exactly what they sound like. One of those millions of options might just be the one you’re buying!

Basically, when someone owns 100 shares of a stock and wants to sell them, he/she “writes” the option. You can think of it as writing up the contract to purchase shares. That might well be where the terms “options contract” and “writing an option” came from, because no one ever says I want to buy a stock contract. That’s just silly. =P This is the most common way option contracts are created, by having someone who owns hundreds of shares sell off the options to them. We call this a covered call or covered put, depending on the type of option being written.

There exists, also, UNcovered calls/puts. In these cases, people borrow shares from their brokerages to write options. I hope you became wary upon reading the word “borrow” because this is a very dicey game to play. To write an uncovered option you really are borrowing money that you don’t have in your account in the hopes that you turn a profit off these options and can then repay your brokerage. If you don’t turn a profit you still have to pay back the brokerage. And if you bought 100 shares to write an option contract for Under Armour, the example we used last time, then you’ll have borrowed about $2,000 worth of UA shares. That would not be fun to pay back if you didn’t have the money to cover your bets options in the first place!

This just about covers what an option is, in the most technical sense. Please comment and let me know if you have any questions!

Also, a quick note: employee stock options are always call options. It makes sense if you think about it, how could they give you put options? That would mean they give you the right to sell options that aren’t yours… now that doesn’t make much sense, does it?

– RT


One Response to Understanding Options For Newbs Part Ia: What is an option?

  1. […] This is episode 3 of Understanding Options for Newbs, so by now we know what options are and what they mean. This is going to be a short, but important post. Plus, the next one’s going to be a doozy. […]

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