Options are a type of derivative security. They are a derivative because the price of an option is intrinsically linked to the price of something else.
Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.
The right to buy is called a call option and the right to sell is a put option. People somewhat familiar with derivatives may not see an obvious difference between this definition and what a future or forward contract does.
The answer is that futures or forwards confer both the right and obligation to buy or sell at some point in the future. For example, somebody short a futures contract for cattle is obliged to deliver physical cows to a buyer unless they close out their positions before expiration. A call option might be thought of as a deposit for a future purpose. For example, a land developer may want the right to purchase a vacant lot in the future, but will only want to exercise that right if certain zoning laws are put into place.
Of course, the landowner will not grant such an option for free, the developer needs to contribute a down payment to lock in that right. With respect to options, this cost is known as the premium , and is the price of the options contract. Now the developer must pay market price. A put option, on the other hand, might be thought of as an insurance policy. Our land developer owns a large portfolio of blue chip stocks and is worried that there might be a recession within the next two years.
These examples demonstrate a couple of very important points. First, when you buy an option, you have a right but not an obligation to do something with it. You can always let the expiration date go by, at which point the option becomes worthless. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are derivatives. In this tutorial, the underlying asset will typically be a stock or stock index, but options are actively traded on all sorts of financial securities such as bonds , foreign currencies, commodities, and even other derivatives.
Owning a call option gives you a long position in the market, and therefore the seller of a call option is a short position. Owning a put option gives you a short position in the market, and selling a put is a long position. Keeping these four straight is crucial as they relate to the four things you can do with options: Here is the important distinction between buyers and sellers:.
Don't worry if this seems confusing — it is. For this reason we are going to look at options primarily from the point of view of the buyer. At this point, it is sufficient to understand that there are two sides of an options contract.
To understand options, you'll also have to first know the terminology associated with the options market. The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above for calls or go below for puts before a position can be exercised for a profit. All of this must occur before the expiration date. The expiration date, or expiry of an option is the exact date that the contract terminates.
These have fixed strike prices and expiration dates. Each listed option represents shares of company stock known as a contract. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. An option is out-of-the-money if the price of the underlying remains below the strike price for a call , or above the strike price for a put.
An option is at-the-money when the price of the underlying is on or very close to the strike price. As mentioned above, the total cost the price of an option is called the premium.
This price is determined by factors including the stock price, strike price, time remaining until expiration time value and volatility. Because of all these factors, determining the premium of an option is complicated and largely beyond the scope of this tutorial, although we will discuss it briefly. Although employee stock options aren't available for just anyone to trade, this type of option could, in a way, be classified as a type of call option. Many companies use stock options as a way to attract and to keep talented employees, especially management.
They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, exists only between the holder and the company and cannot typically be exchanged with anybody else, whereas a normal option is a contract between two parties that are completely unrelated to the company and can be traded freely.
Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. How Options Work Options Basics: Types Of Options Options Basics: Options Spreads Options Basics: Options Risks Options Basics: Buying and Selling Calls and Puts: Four Cardinal Coordinates Owning a call option gives you a long position in the market, and therefore the seller of a call option is a short position.
Here is the important distinction between buyers and sellers: Call holders and put holders buyers are not obligated to buy or sell. They have the choice to exercise their rights if they choose. This limits the risk of buyers of options, so that the most they can ever lose is the premium of their options.
Call writers and put writers sellers , however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have unlimited risk , meaning that they can lose much more than the price of the options premium.
Options Terminology To understand options, you'll also have to first know the terminology associated with the options market. Learn more about stock options, including some basic terminology and the source of profits. Trading options is not easy and should only be done under the guidance of a professional.
Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction Options are valued in a variety of different ways.
Learn about how options are priced with this tutorial. Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums. A look at trading options on debt instruments, like U. Treasury bonds and other government securities. Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
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