What is Options?
In derivatives, an option contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (the strike price) on or before a certain date (the expiration date). This is a key distinction from futures contracts, which obligate the holder to buy or sell.
Key characteristics of option contracts:
Right, not obligation
The buyer of an option can choose whether or not to exercise their right. They are not forced to complete the transaction.
Strike price
This is the predetermined price at which the underlying asset can be bought or sold.
Expiration date
Options have a limited lifespan. They expire on a specific date, after which they become worthless if not
exercised.
Premium
The buyer of an option pays a premium to the seller for the right to exercise the option.
Types of options
Call option : Gives the buyer the right to buy the underlying asset.
Put option : Gives the buyer the right to sell the underlying asset.
Example:
Imagine a call option on a stock trading at $100 with a strike price of $110 and an expiration date in one
month. The buyer of this option pays a premium (e.g., $5).
- If the stock price rises above $110 before the expiration date: The buyer can exercise the option, buying the stock at $110 and potentially selling it at the higher market price, making a profit.
- If the stock price stays below $110: The buyer can let the option expire worthless, limiting their loss to the premium paid.
- The seller of the call option (also known as the writer) receives the premium and is obligated to sell the stock at $110 if the buyer chooses to exercise the option .