Explain Option Trading: Farmer Fred invents the option
An option is a deal between two people where one is to buy something from the other, or sell something to him. Now, how is this different from any normal agreement you ask? Well, in a normal agreement the two people involved decides that the deal should be done, and neither one of them can back out. Let’s look at an example.
Farmer Fred grows wheat and when harvesting season approaches he contacts the local mill wondering if they are interested in buying his wheat. Miller Miles at the mill thinks this sounds like an excellent idea and they decide that Farmer Fred shall deliver the wheat to the mill after harvest and get paid 100$ for each barrel.
This very normal and simple deal is sometimes called a FUTURE or FORWARD contract. With an option however, the agreement is that one of the parties, but not the other, has the right to back out if he wants to. So while in a normal agreement both parties have equal rights, with options this is not the case. Back to Farmer Fred:
Fred thinks that maybe the market price of wheat will be higher than 100$/barrel at harvest time. In that case he would feel stupid having to sell wheat to Miller Miles for 100$. So he thinks: maybe I can make an agreement with Miles that I can sell the wheat to him for 100$ if I want to?
In this case both parties are not equal. Fred can sell the wheat to Miles if he wants to but Miles has to buy the wheat if Fred decides to sell it to him. This is an option contract and now you realize why it’s called an option. It’s because one party has the option to go through with the deal or back out.
The right to sell wheat to Miles that Fred hopes to get is in option language termed a PUT OPTION. The term for a deal where one party has the right to buy something is CALL OPTION. Put and call options are the two basic versions of options. Below is an example of a call option just to make sure you are familiar with them.
Farmer Fred feels pretty satisfied with idea for a put option. He has one more worry though. Prices of fuel for his machines might move a lot up and down and it’s hard for Fred to make ends meet as it is. What if fuel prices are so high at harvest time that he doesn’t make much money at all this year? Fred could buy all the fuel he needs and store it in his tank on the farm. But what if fuel prices go down instead of up? That would make him feel as stupid as if he had sold wheat to Miller Miles under market price.
Fred decides to give Gas station Gus a call. Maybe they can work something out? Fred proposes to Gus that he should be able to buy fuel from Gus at 10$ per gallon at harvest time, if Fred wants to. What Fred just proposed to Gus is a CALL OPTION.
There are a bunch of other terms that options traders use. The price at which the sale or purchase should take place is called STRIKE PRICE or EXERCISE PRICE. These two terms are both common and you will hear both of them used by option traders and option brokers. No need to feel embarrassed if you use one and your broker or option trader colleagues use the other. The date that the sale/purchase is agreed to take place is, not surprisingly, the DELIVERY DATE. Often options traders talk more about how long time there is left to delivery than the actual delivery date. They refer to this as, no surprise again, TIME TO DELIVERY.