The Definition of an Option

An Option is a contract between a buyer and a seller.

This contract gives the buyer…

• the right, but not the obligation
• to buy (or sell) an asset
• at a fixed price
• before a predetermined date.

For those of you unfamiliar with options this definition may seem complex at first, but don’t be discouraged.  You’ll see as we walk through it step by step that it’s actually quite simple.

Let’s look at a possible situation in real estate to explain how options work.

Example: Bill, a home owner on the coast of Florida, purchased a home several years ago.  His home has increased in value nicely in the last few years, but he feels that the local real estate market is getting soft.  He believes that in the next 6 months the market value of his home will either remain at current prices or perhaps even decrease slightly.  At this point Bill begins to wonder if he should consider putting his home on the market to lock in his gains with the proceeds from the sale.  

Meanwhile Jennifer, a prospective buyer in Bill’s area, is looking to buy a home but she won’t have the complete down payment saved for several more months. Contrary to Bill’s opinion, she believes that the local real estate market will continue to rise at a fast pace in the next 6 months.

Around the Holidays, Jennifer hears through a mutual friend that Bill is considering selling his house.  She knows the house well and has had her eye on it for some time.  So she approaches Bill with an idea.  Jennifer is willing to pay Bill a premium to keep his home off the market while she finishes saving up a down payment.  All she asks for in return is the right to purchase Bill’s house at predetermined value any time before July 1^st.  (Remember, Jennifer believes the home will be worth much more in 6 months time.)  If she chooses not to purchase Bill’s home, he gets to keep the premium that Jennifer paid him.

Because Bill believes that the market price of his home will not increase during this period he sees this as a great deal.  Jennifer will only choose to buy his home if it has appreciated, which he is quite confident it won’t.  Either way, he keeps the premium Jennifer pays him.  In his mind this is a great way to pick up some additional income over the next 6 months.

On January 1st, Bill sells Jennifer an option contract on his house for $5,000 giving Jennifer the right, but not the obligation, to buy Bill’s home for $400,000 until July 1st. (About 6 months).

Revisiting the definition of an option from above, the option (contract) that Jennifer purchased provides for…

• the right, but not the obligation
• to purchase an asset (Bill’s house)
• at a fixed price ($400,000)
• before a fixed date (before July 1st )

Call Options

In the world of options trading, the option contract Jennifer purchased on Bill’s house would be termed a Call option.  A Call option is a bullish option contract.  In other words, the buyer of a Call option believes the underlying asset will increase in value.  In this case, Bill’s house would be that asset.  Let’s review the terms of the Call option for the buyer and the seller in our house example:

BUYER (Jennifer)

 the right, but not the obligation

 to purchase the asset (Bill’s house)

 at a fixed price ($400,000)

 before a fixed date (July 1st )

SELLER (Bill)

 the obligation (if the buyer – Jennifer – chooses to exercise his/her right to purchase)

 to sell the asset (Bill’s house)

 at a fixed price ($400,000)

 before a fixed date (July 1st)

Results at Expiration of a Call Option

Below are three possible scenarios that may occur at the expiration of the house Call option contract on July 1st:

1) The house is now worth $440,000.

Jennifer exercises her option and buys Bill’s house for $400,000. Her total cost is $405,000 ($400,000 for the house + the $5000 premium she paid Bill for the option). At this point Jennifer has made a profit of $35,000.  ($440,000 market value - $405,000 cost)

2) The house is now worth $405,000.

Jennifer exercises her option and buys Bill’s house for $400,000. Her total cost is $405,000 ($400,000 for the house + the $5000 premium she paid Bill for the option).  At this point Jennifer has broken even ($405,000 market value - $405,000 cost) and she owns the house which has the potential to continue to increase in value in the future.

3) The house is now worth $380,000.

Because the market value of Bill’s house is now less than $405,000 (Jennifer’s breakeven point) she does not exercise her option and lets the contract expire worthless since she could buy Bill’s home on the open market for less than $400,000. Jennifer loses the $5000 she spent on the option, but she can still afford to buy a home with her down payment. Bill keeps the $5000 he received for the option which reduces his losses and he still owns his home.

Basic Call Option Terms

Strike Price: Price at which you have the right to buy the underlying asset

(e.g. Bill’s house at $400,000)

Option Premium: The price of the option (contract) that you purchase.

(e.g.  The $5000 to buy Bill’s house at a fixed price of $400,000.)

Expiration Date: The date at which the option contract (and the buyer’s right to exercise their option) expires.

(e.g. The July 1^st expiration of Jennifer’s option contract on Bill’s house).

Exercising an Option: Buying the asset from the seller at the fixed price on or before the expiration date.

(e.g. Buying Bill’s house for $400,000 on or before July 1st.)

Breakeven: The value that the asset must reach for your option to become profitable. (e.g. $400,000 Strike Price + $5,000 Option Premium = $405,000 Breakeven)

To learn about how options are applied to stocks, go to our Options Building Blocks key.