What Exactly is Option Trading?

At its most simple, an option--any kind of option--gives you the right (but not the obligation) to buy something for a certain price for a certain period of time.

The Zucchini Story

Let's say the farmer next door plants a whole field of zucchini vines in April. You love zucchini, and you want to be sure you get some once they're ready. So the farmer sells you an option to buy 10 lbs. of his zucchini for $1.00 a pound anytime between June 1 and July 1. You pay him a buck for the option, which guarantees that you'll get the zucchini you want when the time comes.

But in May all the zucchini plants in the state are hit by a devastating zucchini blight, and most of his crop dies on the vine. The zucchini that are left are now selling for $7.50 a pound because they're so scarce. But you've purchased an option to buy up to 10 lbs. of zucchini for $1.00 a pound anytime between June 1 and July 1. So if you exercise your option, the farmer must sell 10 lbs. of his zucchini to you for $1.00 a pound. However, you are not obligated to buy…you have the option of buying, but not the obligation.

So how do you make money trading options?

Let's go back to the zucchini story. You own an option to buy 10 lbs. of zucchini for $1.00 a pound, even though it's now selling at the retail price of $7.50 a pound. But your aunt in Fresno has had a bumper crop of zucchini, and she's mailed you a 15 lb. box of it. So you're not in the market for zucchini.

But you still have this option to buy zucchini for $1.00 a pound, and you have a neighbor who loves zucchini…and would love to save a few bucks a pound. So your neighbor buys your option from you for $10 and exercises it herself on June 8th. (You paid the farmer $1.00 for the option, and you sold it to your neighbor for $10, for a profit of $9--not bad!)

Buy low, sell high

By purchasing your option, your neighbor is able to buy $75 worth of zucchini from the farmer for just $10. She paid you $10 for that option. So her $75 worth of zucchini cost her just $20 ($10 to the farmer, and $10 to purchase the option from you.)

That option was valuable, and could be sold at a profit, because it gave the bearer the ability to purchase something for below current market price.

This is just one example of how options trading works. This example is analogous to a "call option" in the world of Stock Option trading, because the owner of the option had the ability to buy the underlying asset (in this case, 10 lbs. of zucchini) at a certain price during a certain time period.

Want to learn more about Stock Options and how you can make money trading them?

Register today for the next session of  "Stock Option Trading: Is It Right For You?"