When the average person gets into personal finance and investing, they generally start with a primer in buying and selling stocks and maybe work with trading various index ETF’s or maybe investing in an index mutual fund. Sometime down the line they then talk to someone who might know a little more about investing or who might even do it for a living and learn about these wonderful things called ‘options’. These ‘options’ have allowed the person to make a huge amount of money with little investment with a leveraged bet or maybe they gave their portfolio a little income by selling covered calls, but for whatever reason they immediately become a fantastic new thing that you must use to invest. Today you will learn what an option is and how it applies to your everyday life, and I promise that it won’t hurt.
Many options primers will be filled with big words that don’t provide much explanation such as ‘iron condor’, ‘vertical spread’, or my favorite, the ‘short calendar ratio spread’. Unless you know a lot about options (and I mean A LOT), these names won’t really tell you much. In fact, unless you want to really take a month or two of full time work to study about options I don’t recommend you use them for investing. Aside from that, you will use options in your work life, and most likely you won’t even know it.
An option is simply a contract between two people where one party agrees to buy a set amount of something from a second party at a later date. In the case of securities (stocks), an option is an agreement to buy or sell 100 shares of stock at a specified price at or before a set date in the future. As I said earlier, without adequate study you should play around with these options but if you work at a publicly traded company you will see another kind of options, and those are generally referred to as ‘stock options’.
As anyone in the working world should already know, a stock option is something that a person who has achieved a fairly high level in a company gets. Basically what they are is a contact that allows someone to buy the company’s stock at a discounted price at some point in the future. They are often a good way to pay something because the person receiving the option will want to work hard so that the price of the stock goes up and they make more money, and the company will therefore get a harder working employee. Additionally, these options are often used as a replacement for a portion of the worker’s salary so the employer gets to free up some extra cash to deploy somewhere else. For our purposes, these stock options are exactly like the stock options that traders and investors use and you didn’t even need a degree in finance to know what they are. For most of you, it may have been told to you a long time ago!