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Options - Basic Education
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Down to earth about options
Options
Traditionally options give you a right but not an obligation to buy (CALL) or sell (PUT) something (UNDERLYING) at a given price (STRIKE). We need a simple example. Let’s go bananas. You can buy bananas options that tell you that you can buy (CALL) bananas at $5 per bunch. $5 is the STRIKE price. Bananas are the UNDERLYING.Now, we use words PUT and CALL that are very specific to options because it would be a bit confusing to say ‘I buy an option to buy bananas’ or ‘I buy an option to sell bananas’. Instead, we say ‘I buy a CALL option on bananas’ and ‘I buy a PUT option on bananas’.So, you may own (HOLD) a PUT option at $5 STRIKE which means that if you have bananas then you can PUT them into the market at $5 a bunch even if the market at the given time buys bananas for $3 a bunch.If you HOLD a CALL option on bananas, then you can call the market and ask them to deliver bananas to you for $5 a bunch even if everyone else has to pay $7 a bunch.Now, after you buy an option then we say that you HOLD it. When you sell (or rather create) an option we say that you WRITE it.
What does it mean to write? (example)
Why do we say WRITE and HOLD? Think of it in the ancient terms. I guess there were no bananas where the options were initially traded and no options where bananas were initially traded but let us imagine some ancient times where an ancient trader was trading ancient bananas. Simply buying and selling bananas can be boring in the long term and also some people are not sure whether they will need more bananas in the winter, so our ancient trader decided to introduce a new instrument – bananas options. Buying CALL bananas options allowed ancient bananas lovers to ensure that they will be able to buy bananas at $5 per bunch in the winter in case they ran out of bananas of their own. Very clever.Imagine how the deal was made. A banana lover would come to the banana trader and say – I need you to sell me an option to CALL bananas from the market at $5 a bunch any time by the end of this year. The banana trader would have to WRITE a document saying: ‘I promise you that if by the end of this year you CALL me to deliver bananas to you at $5 a bunch then I will do that’. Now, just after WRITING this document, the bananas trader HOLDS it in their hands. If they decide to sell it to the banana lover then the banana lover will receive the document and HOLD it in their hands. So, think of an option as a document, written contract, between the buyer (HOLDER) and the seller (WRITER). And to buy the contract you have to pay a price for it, called PREMIUM. So, the price of the option itself and the price of the bananas are two separate things. The price of the option contract can be derived from the historical prices of bananas. The option on bananas is a derivative of a simple trade of buying or selling bananas at the current price.Since the HOLDER has a right to CALL bananas from the WRITER, they can choose to EXERCISE that right (they do not have to, but they can).Interestingly, the banana lover can sell the option contract to another banana lover. At sale the contract changes hands and the new owner HOLDS the contract now. The price paid is not a price of bananas but the price of the option.
Last modified 2mo ago
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