What Is an Option, and How Do Options Work?

To many, options are confusing and complex financial contracts, but they do not have to be. In Chapter 1, we discuss the mechanics of options and explain that they are just a financial arrangement that give the owner of the option the right to either buy or sell an asset. From there we discuss the characteristics of options and factors that affect an option's value. An important part of the mechanics of an option is the process by which the owner exercises an option and how exchange traded options are assigned the option writer (seller). Moneyness and volatility are the two most important characteristics that drive an option's value. This chapter defines those characteristics and show how they are calculated. Furthermore, the value of a put call and the underlying asset such as the stock are interrelated. That relationship is discussed through the concept of put-call parity. Options are levered financial contracts and this leverage must be understood to manage the instrument's risk characteristics. Since options are created with an expiration date, they fall in value as they age. This process of time decay is a very important factor in an option's return dynamics.