Option Definition

Wikipedia provides an excellent history and explanation of options and their uses. One of the largest options exchanges in the world exists in Chicago: The Chicago Board of Options Exchange (CBOE). An option, simply, is a side bet. It is a "side bet" on the underlying stock. Let's look at an example. Let's say we buy 100 shares of Caterpillar @ 70/share. Let's look at what happens if the stock goes to either 65 or 75:

stock price return on investment
65 -7.1%
75 +7.1%

Now let's look at the power of options. Instead of buying 100 shares of Catpillar, let's say we instead buy a deep in the money call option. Say we buy a Caterpillar option for $20 with a strike price of 50. Now let's look at what happens if the stock again goes to either 65 or 75:

stock price return on investment
65 -25%
75 +25%

The difference between buying the underlying stock and buying a call option replacement is staggering. Clearly buying the option in this example is much riskier than buying the underlying stock. Options can be very powerful, and very versatile. By combining options with the underlying stock or even another option, many different strategies surface. Some of the more common strategies are included below:
covered call ShortPut.gif

bear spread BearCallSpread.gif

butterfly LongButterflySpread.gif

Many more of these various strategies exist and a more in depth explanation can be found here.

Additional information from the text:

Difference between American and European options:

American - the right to buy or sell a unit anytime on or before the expiration date of the option.

European - the right to buy or sell on a specific date - the expiration date.

Most exchanges trade American options. The Chicago Board Options Exchange, S&P 100, and S&P 500 all trade American. Although this is true, European options are easier to value because they only have to worry about one period of time, the expiration date.

4 features of an option as discribed in the text:
1) "An underlying risky asset that determines the option's value at some future date."
2) "A strike price."
3) "An exercise commencement date, before which the option cannot be exercised."
4) "An expiration date beyond which the option can no longer be exercised."