What an option is
A voucher that locks in a price for a while. You pay for the voucher, and you never have to use it.
Imagine a shop sells a bicycle for £200. You think the price might go up soon, but you are not ready to buy today.
So you ask the shopkeeper for a deal. You pay him £10 now, and in return he promises that for the next three months, you may buy that bicycle for £200 whenever you like — even if the price in the shop has gone up to £300.
That promise is an option. And you have just learned the whole idea.
The three things that make it work
- You paid for the promise. The £10 is gone whatever happens next. That is the price of the option.
- You have a right, not a duty. If the bicycle drops to £150, you simply do not use your promise. You buy at £150 like everyone else and your £10 was wasted.
- It runs out. After three months the promise is void, and the shopkeeper owes you nothing.
An option is a paid-for right to buy or sell something at an agreed price, on or before an agreed date. Everything else in this track is detail attached to that sentence.
What it is worth
Ask yourself what the promise is worth in two different worlds.
- The bicycle rises to £300. Your promise lets you buy at £200, so it is worth £100 to you. You paid £10 for it.
- The bicycle falls to £150. Your promise lets you buy at £200, which is worse than the shop price. It is worth nothing.
Notice something important: the most you can lose is the £10, no matter how far the bicycle price falls. But the amount you could gain has no fixed ceiling, because the price could go to £400 or £1,000.
A small, known, certain loss in exchange for a large, unknown, uncertain gain. That shape — and its exact mirror image, which we come to later — is the reason anyone bothers with these contracts at all.
The same thing, in financial language
Swap the bicycle for a share and you have a real option contract. The vocabulary changes; the idea does not.
| The shop | The market | What it means |
|---|---|---|
| The bicycle | 100 shares of a company | The thing the promise is about |
| £200 agreed price | The strike price | The price you are allowed to pay |
| Three months | The expiry date | When the promise dies |
| The £10 you paid | The premium | What the promise cost you |
| The shopkeeper | The option writer | The person on the other side |
One thing to hold on to
The shopkeeper is not doing you a favour. He took your £10 because he believes the bicycle probably will not rise enough to matter. He is making a bet too, and his bet is the opposite of yours.