In our previous article (How not to use options), we mentioned about options. Today, for those of you who are uninitiated to the world of options, we will give you a quick introduction. For more in-depth information about options, we recommend the books in the ?Derivatives? section in Recommended Books.

First, let us have a brief introduction on options. When you buy a call option of a stock, you are purchasing the right (but not the obligation) to buy the stock at a specific price (the exercise price in the option?s contract) on and before the option?s expiry date. Correspondingly, when you buy a put option, you are purchasing the right to sell the stock at the exercise price. Technically, when you buy a call (put) option, you are said to be entering a long call (put) option position, or simply ?long? a call (put) option.

The interesting thing about options is that you can also ?create? them for sale. When you sell a call option of a stock, you may be obliged to sell the stock at a specific price if the buyer of the option chooses to exercise his/her right to buy from you. Correspondingly, when you sell a put option, you may be obliged to purchase the stock from the buyer of the option. Technically, when you sell a call (put) option, you are said to be entering a short call (put) option position, or simply ?short? a call (put) option.

When you initiate an option purchase or sale, you are said to ?open? an option position. To ?close? an option position, you enter an opposite option transaction?sell back the purchased option or purchase back the sold option.

A good way to understand options is to see them as akin to insurance. When you enter a long call (put) option position, you are in effect purchasing ?insurance? against the rise (fall) of the underlying stock price. When you enter a short call (put) option position, you are in effect underwriting ?insurance? for the rise (fall) of the underlying stock price. So, option trading is a game of probability?the same way insurance companies are in the business of pricing probability of events for profit. Therefore, as in the insurance business, the option trader has to accurately ascertain the price of probabilities accurately in order to profit.