OPTION Basics (1) (What is an Option?)

One of my plans is to use this blog to share what I know and learn on option trading, other than creating a place to welcome anyone to share their experiences and success stories and even set backs.

So...What is an Option?

An option is a contract that provides the buyer/seller with the right to buy or sell the underlying stock (100 shares) at the specified fixed price (strike price) by the specified date (expiration) in the future.

A unit of an Option is called a contract. A contract consists of 100 shares of the underlying stock.

Strike price refers to the price which the buyer/seller agree to transact on irrespective of the actual price of the stock in the future.

E.g.

Mr. A buys “1 AIG Aug 12 Call at $1.50”.

1 – number of contract (100shares/contract)

AIG – the underlying stock

Aug – Option expiring month (Option expires on the 3rd Friday of each month)

12 – is the strike price

Call – Call option

$1.50 is the premium Mr. A pays for this contract. This $ is stated as per share basis.

So $1.50 X 100 shares => Mr. A is paying $150 of premium (excluding transaction fees)

In essence, Mr. A is buying the right to purchase 100 shares of AIG at the price of $12/share between the point of transaction till the expiry date.

Mr. A pays $1.50/share (the premium) to attain this right.