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Options - explained


In short, option gives the buyer the right but not the obligation to buy or sell an underlying asset at a set price during the life of the contract. They are considered financial derivative namely derivative is a financial instrument with a price that is based on an underlying asset. In other words price of the option derives its value from the underlying assets that can be futures, commodities, currencies, securities or indexes. Usually they are purchased through online or retail broker. We will discuss stock options where underlying asset is stock. For example option on stock ABC gives option holder the right to buy or sell ABC stock at a strike price up until expiration date. In this case underlying asset is ABC stock because the price of the option is based on the stock price.

Writing an option refers to investment contract in which fee is paid for the right to buy or sell shares at a predetermined future date. The fee paid depends on several factors like current price of stock, expiration date and stock volatility.  When writing an option, price that refers to price of underlying asset (stock) at which option can be exercised is called strike price. Options are usually sold in lots of 100 shares so if you buy an option for $1 that means that buying one option costs $100 (1$ x 100). Option contract will also have an expiration date, typically occurring in calendar year quarters. Buyer can choose not to exercise an option and lose the amount payed for the option. His decision is influenced by current stock value on the market, whether option is in or out of the money. Options can be exercised at any time before the expiration date. 

Call option provide buyers with the right to buy stock at strike price at a certain future date.This means option buyer wants to stock to go up. If a buyer bought an option for $2, he paid $200 for it, with a strike price of $50. If a stock price rises to $55 and buyer exercise the option meaning that he bought 100 shares for a $50 and than sold those shares for $55 each making $500 for the difference in the trade. When the option price of $200 is subtracted the final profit that option holder made is $300. On the other hand option writer hopes that stock price will drop or stay the same during the life of the option.  Writers maximum profit is the premium paid which makes it limited but the risk of potential loss is unlimited because price can rise to unlimited amount. If stock price falls option holder will not exercise the option and lose the premium paid for the option which means that his loss is limited.

Put options give option buyer the right  to sell stock at a strike price so naturally buyer wants stock to go down and option writer hopes that stock will go up. If stock price falls below the strike price writer is obliged to purchase the shares at a strike price. If stock closes above strike price buyer will not exercise the option and writer will make profit.
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