What is an option?

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It's more than just an offensive football play, as Merriam-Webster's Collegiate Dictionary likes to describe it. An option is an investment contract that allows an investor to buy or sell a set amount of an underlying security at a predetermined price and by a predetermined date. 

Options trade on a variety of instruments, including stocks, equity indexes, exchange-traded funds (ETFs), interest rates, and currency and commodity futures.   Throughout this program, however, we will typically refer to a stock as the underlying security. Because options prices are derived from the underlying securities, they are known as one type of derivatives.  

An option contract usually represents 100 shares of the underlying stock, even though they are commonly priced on a per-share basis.  Thus, a stock option you see priced at “$2” on an option chain will cost an investor a total of $200 per contract ($2 times 100 shares).  Thus, if you wanted to buy three option contracts at this price, your cash outlay (before commissions) would be $600 and you would control 300 shares of stock. 

Just like shares of stock, options can only be traded in one-contract increments.  For example, if you wanted to trade $2,000 in the $2 option above, you would only buy an even 10 contracts.  Even if you had $2,100 available to invest, you could buy only 10 contracts (i.e., you can't buy 10-1/2 contracts). By extension, an option almost always represents a factor of 100 shares of the underlying. 


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