An option is a type of tradable. It is a contract that gives the owner the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified price on or before a specified date.
The seller (option-writer) incurs the obligation to fulfill the transaction, if the buyer (option-holder) chooses to "exercise" the option before it expires. The price of the option compensates the seller for upholding that obligation.
An option that conveys the right to buy at a specific price is called a call. An option that conveys the right to sell at a specific price is called a put.
Puts are used for, calls are used for .
Upon expiry of the deadline or specified period, the option becomes invalid. The price of the option compensates the seller/writer for the risk he takes on.
Options can be used for speculating on theof an asset. However, this is very risky because both the time factor and the actual price are important.
The stock price of company A is currently at $10. You expect it to rise steeply, so you plan to buy a call option.
You buy a call option for the risk premium of $1. It allows you to buy the stock for $10 (today's price). The option expires after one month.
Three things can happen:
- You were correct – after one week, the price of the stock rises to $15 per share. You execute the option and buy the stock for $10, and sell it for $15. After deducting your risk premium of $1, you are left with a profit of $4.
- You were wrong and the price drops to $7. You don’t execute your option and end up losing just the -$1 you paid for the option – much less than if you would have bought the stock directly.
- There is no significant change in the stock’s price and the option expires after one month because you didn't execute. However, you still have to pay the risk premium and end up with a loss of -$1.
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