An option is a contract. There's both two sides to any contract, there's the buyer of the option and the writer of the option. So there are two kinds of options, I've already alluded to that. A call option is a right to buy. A put option is a right to sell at your discretion. With a call option, you are buying the right to buy something which is specified in the contract at a predetermined price. That means you don't have to wait to find out what your market price is of that item on the day of purchase. It's locked in in advance. But we call it an option because you don't have to purchase it, you can wait and see. It's different from a forward contract to buy something, because in a forward contract, you are not only having the option to buy, you are committed to buy. You signed a contract, a forward contract, to buy something in the future. It means, I promise to buy it. Both sides are bound. The buying side of a forward contract is bound to buy. The selling side is bound, promised, to sell at that price. But options give a choice to the buyer of the option. And at the time that the option is bought, the buyer of the option compensates the seller, or they call it the writer, of the option. Because the writer of the option is now subject to the choice in the future of the buyer of the option. And it has to be compensated for giving that choice to the other person. So what is the essence of options? Some people think it has something to do with free will. That is, that you can do whatever you want and maybe you will be happy, happier in the future if you buy it, or maybe you won't. You can wait and see. But actually in finance, it doesn't have much to do with free will or feelings generally. You will generally buy the option if it pays to do that in finance, most people will. So if it's a call option, it's an option to buy something. You will buy it on the date specified if the price of buying it through the option is less than the price of buying it in the open market. Because you will always do that, even if you decide you don't want the object, because you can then sell it in the open market and make a profit. So options are truncated claims on asset. If it's a call option, it means that it's a claim on the price only if it rises above the contract option price. So that's the general idea. And so let me get a little bit more precise. The contract of the option have these terms, an exercise date or a strike date. That's the date when the option expires, and you either have to buy if it's a call, or sell if it's a put. And if you don't, then the option becomes worthless. And forever after it's worthless, it's expired. It also specifies as the exercise price or a strike price. Which is the price at which you are, in a call option case, have the right to buy, and in the put option case, where you have the right to sell. The contract also has to specify what is the underlying, what is the object that has to be bought or sold? And how many of that, if it's shares. Now options are not just for stocks. For example, suppose you are a builder and you're building a shopping center. You want to build a shopping center in the city, near a city. So you look around and you find, well, there's some farmland here that looks well-positioned. Maybe I want to build my shopping center on this guy's farm. But he's a farmer, right? He doesn't know you're coming. So you walk over to him and you say, I'd like to buy an option on your farm. We haven't really finalized this deal to build a shopping center, but maybe we'll change our mind. But we want to know that we can get your farm. And the farmer might first say, no way, you want my farm? [LAUGH] And then you say, look, it's just an option. If it expires unused, you just keep the money. So maybe the farmer will do that. And he'll think about it and say, well, the guy is offering me money right now, maybe nothing will come of it. So that's an example of an option. And it undoubtedly has a long history. There must have been many times, going back to Sumerian times, if you listen to Bill Getzman [LAUGH], when people thought of that. I'm thinking of buying something, but I don't know that the seller is willing to sell, so you would buy an option.
