An Example of an Option

The best way to understand an option is to use an illustration. (This example is for illustration only, and should not be construed as expected values for options, or expected returns.) Imagine a savvy investor is looking to buy some real estate. During his search, he notices someone is selling 10 acres of land for $10,000 each ($100,000 total). During this time, he also comes across a very interesting rumor. A friend of his that works at the planning office tells him that there is talk of a new shopping mall being built in a particular section of town, just a couple miles from the land he saw. He knows that if the mall is built, the price of land will skyrocket. However, if it isn’t built, he knows he’ll be stuck with some property he didn’t want. He presents the seller of the land with an interesting proposition: he will give her $10,000 to let him buy the land within the next three months. If he decides to purchase, he’ll pay the full $100,000. If he decides not to purchase, the seller can keep the money. Thus, he’s not buying the land…he’s buying the right to buy the land.

This would be referred to as a CALL option, because it’d allow him to buy within a given period of time. (A PUT option would allow him to sell within a given of time.)
The Underlying would be the 10 acres of land, because that’s what he would receive if the purchase took place.
The Premium would be $10,000, because this is the amount he must pay to enter into the agreement.
The Strike would be $100,000, because that’s the price he’d pay the seller for the underlying.
The Expiration would be three months, because that is how long the agreement is valid.

If the rumor became true, he could Exercise his option, and buy the land for the agreed upon price of $100,000. (Note: the $10,000 paid to enter the agreement wouldn’t go toward this purchase).