An option is a financial contract that gives the buyer the right to buy or sell an underlying asset at a set price before a specific date.
Options belong to a class of assets called derivatives. This means they do not have intrinsic value on their own. Instead, their value comes from another asset, such as a company stock or a commodity.
Key Parts of an Option
Every option contract has basic rules and terms:
- Underlying Asset: The stock, bond, or index the option is tied to.
- Strike Price: The agreed-upon price to buy or sell the asset.
- Expiration Date: The final day the contract is valid.
- Premium: The upfront price paid to buy the option contract.
The Two Main Types of Options
Investors use two main types of option contracts depending on their market outlook:
- Call Option: Gives the buyer the right to buy a stock at the strike price. Investors buy calls when they think the stock price will go up.
- Put Option: Gives the buyer the right to sell a stock at the strike price. Investors buy puts when they think the stock price will go down.
How Options Work as an Asset
When you buy an option, you own a legal contract. You can trade this contract on public markets before it expires.
- The Buyer’s Risk: The most money a buyer can lose is the premium paid for the contract.
- The Buyer’s Reward: Profits can be high if the stock price moves in the right direction.
- The Seller’s Risk: The person who sells the option takes on the obligation to fulfill the trade, which can lead to large losses if the market moves against them.