If you look up the word option in a dictionary, you will find a lot of definitions. It mainly represents a choice, the power of choosing something. In everyday life we are faced with many options.

In financial lingo, stock options are a particular type of choice, as explained above. Options in themselves are very powerful financial instruments. They can serve well a conservative investor as well as a risky trader.

Let’s look at a real life example. Suppose your neighbor puts up for sale his old Mustang. You’ve always wanted that car, but could not afford it. You go over and offer him $20.000, although you are a bit short. You also promise that in three months, if you get the rest of the funds, you will make the purchase. For this agreement you pay him $500. In turn, he promises to keep the car for you at the agreed price, even if somebody offers him more.

Suppose other potential clients come around and outbid you. The neighbor would have to keep his word and sell for the $20.000. This way, you get to acquire an expensive car with a good discount. On the other hand, if in the meantime you learn there is a significant hidden problem with the engine, you can back out, losing only the $500 premium.

In the financial markets, options are very similar. Their underlying assets are usually company shares, instead of the car. If stock goes up, you get good stock at a low price. If it goes down, you only loose the option premium.