An Option is the financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a set price. The buyer of the option has the right, but not the obligation, of buying or selling the asset as established by the contract until such time as the option expires, while the seller of the option has the obligation to fulfill the contract if so requested by the buyer.

To explain it in layman\’s terms:

You find an antique car you love, however you do not have the available cash to buy it immediately. You talk to the seller and he agrees to sell it to you in two month\’s time for £20,000. However, for this privilege you have to pay him £1,000.

Two different scenarios can arise in the two month\’s wait. The first is that the antique car you so loved is rotting everywhere, it will not run any more and it is definitely not worth the £20,000 the owner wants for it. Whilst your heart is breaking at the sad news, because you bought an option, you do not have the obligation to go through with the sale. Although you do lose the £1,000 the option cost you. The second scenario is that it has been discovered that the antique car you so love, was commissioned by a wealthy sheik who built it in gold and is worth ten times £20,000. However, because the owner sold you the option to buy it for £20,000, he has to sell it to you for £20,000. In this scenario you would make a profit of £179, 000. If the car is worth £200,000 you would discount the £20,000 you paid for it plus the £1,000 the option cost you.

As you can see through this example, when you buy an option, you acquire the right to do something, but you are not obliged to do it. Options have expiration dates, if you do not want to act on the option you bought, you would let the expiration date run its course and the option then becomes worthless. In this case, you would lose 100% of the money you spent on buying the option (this is your investment).

Another important factor about an option is that it is a contract which is based on another asset – this would be the car in our example. This is why options are called derivatives, because the option derives its value from some other asset. Normally these assets are stocks, bonds, currency or futures contracts.

There are two main types of options, a call option and a put option.
A call option is that option which gives the holder the right to buy an asset at a specified price within a specified time. In order for them to make a profit, holders of call options hope that the stock will increase in price before the option expires.
A put option is that option which gives the holder the right to sell an asset at a specified price within a specified time. In order for the put option holders to make a profit, the stock price will have to decrease before the option expires.

The people who buy the options go by the name holders, whilst those who sell the options go by the name writers.

The holders, whether they are call or put holders, have the right to buy or sell before the expiration date but are not required to do so.

The writers, whether they are call or put writers, are required to buy or sell if the holder decides to exercise the option.

When the option is agreed upon, it is called writing the option and the fee the buyer pays for the option is called the premium. The premium is decided depending on different factors such as the stock price, strike price, volatility, and time remaining until expiration of the option. The more time is left, the more money the premium will be as there are more chances for the stock to move up or down, and vice versa. Determining the premium of an option is complicated. The Greeks model we discussed in another article is used for this very purpose.

The price of the asset which is specified by the option is called the strike price, or exercise price. This is the price the buyer would be paying for the asset when the option is exercised. To exercise an option is the same as to activate an option by trading the asset at the specified price.

For call options (remember: this is the option that gives the holder the right to buy) the option is said to be in-the-money if the share price is above the strike price.

For put options (remember: this is the option that gives the holder the right to sell) the option is in-the-money when the share price is below the strike price.

The amount by which an option, whether it is a call or a put option, is in-the-money is called intrinsic value.

Author Bio: Follow D. Wood\’s blog to learn about trading in the markets, or better yet learn through our training course

Category: Finances
Keywords: what are options, learn about options, call option, put option, learn to trade the stock market