I can understand why people who wants to learn about option becomes easily confused with it. Simply, there are (too) many terms and definition that need to be understood. Even worse, the term with the same name will have completely opposite meaning depends on the type of the options. And with so many of them, no wonder some people just give up.

But please don’t give up as yet ! Not until after reading this article. I will explain all basic and fundamental that you need to know about option in plain English as practical as possible.

This tutorial will be divided into several parts below:

• Part 1: Basic Of Options
  The basic understanding of Option including: the mechanism behind option trading, the type of an option. You need to fully understand this part before proceeding to other part.
• Part 2: Why Option is an Absolute Beauty
  Explain the crucial role and importance of option in the trading world, especially share market.
• Part 3: Around the money
  The clear explanation about ‘At The Money’, ‘In the Money’, ‘Out The Money’ and its importance
• Part 4: Transaction in Option Trading
  Explain the needed understanding before you do any option transaction in the share market.
• Part 5: The Summary of Option Fundamental
  A comparison side by side in a neat table to summarize all the basic option understanding.

On each part, there will be a multiple-choice quiz to help you check your understanding.

Note: should the link it’s not ready, please wait several days as I make some final editorial review.

1. Contract: Promise you must keep

Let us start with something simple, but it’s very important. What is a contract?

Well, contract is basically a legal promise or formal promise. The patrons of a contract promise something to each other. People break promise all the time, but if you put that promise into a contract, you cannot just break the promise without bearing the consequences.

For example: you want to buy a new car. Let say, this new car will only be available at the end of next month. You really like this car and it is your opinion that once this car is available next month, it will become such a hot car and the price might go up as too many people want it. So, you want to secure the price now. The dealer said that they will sell you the car for $30,000 if you pay 10% deposit now. Should you agreed, the dealer will ask you to sign a car sales contract outlining that they will sell the car for $30,000 next month once it become available, that you will put $3000 as deposit, and that you will pay the balance upon delivery.

Once that sales contract is signed, then you are obligated to buy that car next month and the dealer are obligated to sell it to you.

What if something happened and you decide to not go ahead with the purchase. Can you just change your mind like that without any consequences? Probably not. Maybe the dealer allows you to cancel the purchase, but they forfeited your deposit.

Now, imagine a contract like that, but it is up to you whether or not you want to proceed with your contract. That is: if you you want go ahead to purchase the car, you simply pay additional $27,000 (the balance), but if not, your deposit will be simply returned and no question asked.

Is there any contract like that ? Yes, introducing Option contract….

2. Option is Privilege.

Basically, Option is just a privilege or right. With ‘normal’ contract ,you are obligated to fulfill the contract, or otherwise face the consequences. But with option contract, you have the privilege to choose whether you want to fulfill the contract or just abandon the contract.

But in order to have this privilege, you need to pay the price. The price you need to pay to have this flexibility is referred as Option Premium or simply Premium. For example: we pay additional $1000 upfront to the car dealer as Premium to have that privilege.

When you buy an option, you buy the privilege by paying the premium. But only the privilege, not the ‘main merchandise’. In this example: $1000 premium that you pay to the car dealer only buys you the privilege to decide later whether or not to buy the car. But the car itself need separate $30,000.

In Option contract, the ‘main merchandise’ referred as “underlying asset” and could be virtually anything: share, property, warrant, future, block of land, car, etc. For example:

• Share option: the buyer and seller agrees to transact the shares at a certain price.
• Property option: the buyer and seller agrees to transact the property at a certain price.
• etc.

On the other hand, the agreed price of the underlying asset is referred as “strike price”

But a contract cannot be valid forever. It always has time limit referred as expiry date. After the expiry date has elapsed, the contract is no longer binding or simply “expired” or not valid anymore. This is also applied to option contract.

So, in the nutshell, Option Contract is simply a deal between buyer and seller where the buyer have the privilege to proceed or not to proceed the deal within certain time frame.

Now, who is the seller ? The seller is just general public. You can be a buyer now but then you can be a seller as well on other time.

Need to be very clear here that the seller is NOT the Stock Exchange or the Option Clearing House. Stock Exchange/Option Clearing House is just mediator and the umpire to make sure everybody play by the market rule.

3. Option’s Triad.

When we are talking about option, there are always 3 (three) major factors:

1. Underlying Asset: what will be transacted?
2. Strike Price : what is the agreed price?
3. Expiry Date : when the contract expired?

This triad constitutes the value of every option and it will always be defined in a option contract.

4. Option Type: Call Option and Put Option

Call Option

Call option is the right to buy an asset at certain strike price on or before certain expiry date.

If you have Call Option for Microsoft share at $30 (expired 17 Jan 2009), then you have the right (not obligation) to buy Microsoft share for $30 each as long as you do it on or before 17 Jan 2009.

Let say, today is 16 January 2009 (before expiry date) and Microsoft share’s price in the market is currently $40 each. Will you use your privilege from the call option to buy the share? Yes. Because once you buy for $30 each, you can immediately sell for $40 each and making profit $10 each share.

On the other hand, let say the price in the market is only $25. Will you use your right from the call option to buy the share ? No. Because you can buy cheaper in the market why pay the higher price.

Put Option

Put option is the right to sell an asset at certain strike price on or before certain expiry date.

If you have Put Option for Microsoft share at $30 (expired 17 Jan 2009), then you have the right (not obligation) to sell Microsoft share for $30 each as long as you do it on or before 17 Jan 2009.

Let say, today is 16 January 2009 (before expiry date) and Microsoft share’s price in the market is currently $40 each. Will you use your privilege from the put option to sell the share? No. Because it’s trading at $40 in the market, so you can sell it in the market for better price.

On the other hand, let say the price in the market is only $25. Will you use your right from the put option to sell the share ? Yes, of course! Because you cannot get $30 by selling in the market (the price is now $25), then it’s time to use the privilege from put option to sell it for $30 each.

5. Buy vs Sell, Buyer vs Seller

We know that for every transaction there will always be at least a buyer and a seller. That is: if you want to buy ’something’ (you are the buyer), there must be another party that want to sell that ’something’ (seller). Otherwise, there will be no transaction.

In other words, if it is a buy for you, it will be a sell for the other party and vice versa.

I need to emphasize this, as this is where the confusion starts. The definitions of call option and put option above are from buyer perspective.

So, if you buy a call option, you have the right to buy the asset on strike price before expiry date. And if you buy put option, you have the right to sell the asset on strike price before expiry date.

From seller perspective, if you sell a call option, you have to sell the asset on strike price only on or before expiry date should the buyer exercise his/her right. And if you sell a put option, you have to buy the asset on strike price only on or before expiry date should the buyer exercise his/her right.

Can you see know why this can be confusing ? If you start to, please stop here and try to re-read above passage until you grasp the understanding. Don’t continue if you still have any confusion, it will confuse you even more.

6. Option is Trade-able: introducing ‘Option Writer’

You are allowed to sell your option to other people. The characteristic of the option (Option Triad) will remain the same, but the premium may change.

Let take an example that you buy a call option for Microsoft share (so you can buy the share at certain price before expiry date should you decide to do so). But long before the expiry date, you already made up your mind that you will not want to buy the share. Since you will not use that privilege, probably somebody else can make use of this privilege. Then, you can simply sell your right back to the market. Now, you are no longer option- buyer, you become option-seller.

Now that you have sold your call option (where the buyer can buy the share should he decide to), what happen if the buyer wants to exercise his right? Remember, you don’t have the share, but now you sold an option that promise the share…. Where you can get the share ? The answer is: from Option Writer.

Option Writer is the first person who sell a option contract to the market.

In term of call option, call-option-writer is the one who actually own the underlying asset, ready to be sold, should the call-option-buyer decide to buy it.

In term of put option, put-option-writer is the one who actually ready to buy the underlying asset should the put-option-buyer decide to sell his/her underlying asset.

The contract within the option is always between the writer and the latest buyer.If you sell your option, the contract of the privilege will be shift from you to your buyer. Since you are not the first person who sell the option, once you sell the option, you have nothing to do with that option anymore.

7. Option is Anonymous

Contrary to popular belief, when option contract is sold , neither the option-writer nor the option-buyer knows each other. Nobody knows to whom his option is being sold to and nobody knows from who this option from.

Option is anonymous. The buyer and the seller is just a number in the market. They don’t know each other. But they are all have to obey the market rule. The term in option contract is enforceable. This is the assurance from the Stock Exchange/Clearing House as the market authority. One of many ways to ensure everybody play by the rule for example is to make it compulsory for every option writer to provide some sort of security (cash or share) as collateral among many others things.

Denis Kristanda