What is an option?

In finance, an option is a contract that gives the right, but not the obligation, to buy or sell a quantity of an asset or instrument – be that a bond, commodity, stock, or currency – at a specific price on an agreed date. Options are very versatile securities, commonly used by traders to speculate.

An option is a financial derivative through which the buyer pays a premium to the seller and earns the right to either exercise the option before it expires, or choose to abandon it; these premium clauses are non-refundable.

Types of option:

There are many types of options, but we shall address the most common kinds.

Call option: gives the owner the right to buy an asset at an established strike price. In this case, the buyer of the option believes the value of the asset in question will go up and he will earn a profit, buying at a price below the market price.

The seller, or writer, of the option expects the price of the asset to drop. If they are right, the option which they have sold is useless, as there is no point in buying an asset above its market price. The seller has then made a profit by selling something for nothing.

A put option works the same way, just in reverse: it gives the owner the right option to sell an asset at an agreed strike price. Conversely to the call option, here the buyer of the option would like the option price to drop. On the other hand, the seller, or writer, of the option would expect the price to rise.

Options vs Futures

The main difference between options and futures is that the former do not require the contract to be exercised. Futures require the asset to be bought or sold, there is no ‘option’ not to exercise the contract.

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Category: Financial Glossary

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