What is an option?

An option is a contract giving the buyer the right, but not obligation,
to buy or sell a security at a specified price (strike price), on or
before a specified date (expiration date).

Confused? Let me explain it with a story...

Say for example you discover a house that you'd love to purchase.
However, you don't have the cash to buy the house at $700,000.
In order to secure the attractive price, you talk to the owner
and negotiate a deal to buy the house in 3 months time by paying
an option of $3000.

There might be 2 outcomes for this transaction:

1) You've discovered that the house has increase in price
to a value of $800,000 within the 3 months due to an
announcement of a big development project for that area.
Because you own the option, the seller is obligated to sell
you the house for $700,000. You make a profit of $100,000.

2) You've found out that no one has stayed in the house since
the death of previous owner 5 years ago. In other words,
the house is haunted! You now consider the house worthless.
Because you bought the option, you are not obligated to pay
for the house. Of course, you can let the option expired
and make a loss of $3000.

An option is merely a contract that represents the underlying
asset which in our case is a stock or an index. It's also called
derivative.

I hope this little story has helped in understanding of how
options are used.

For your information, options are not available on every stock.
There are approximately over 2000 stocks that are optionable.
Trust me, you only need to trade a few at one time to make
a substantial profits.

There are 2 types of options, and I'll elaborate them more in
the next post.