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Options Basics
A broad definition of an option - a contract which gives its holder the right, but does not require them, to buy or sell shares of an underlying security at a specified price on or before a given date. After this given date, the option expires. Understanding Options An option is a contract that gives the buyer of the option the right to buy or sell an underlying asset on or before a predetermined date, which is called the exercise date, at a predetermined price, which is called the strike price. For the privilege of owning this right, the buyer pays a nominal amount called ‘Premium’ to the seller of the option, who can also be called the ‘Writer’ of the option. While the buyer has the option to exercise the contract, the seller of the option is obliged to sell or buy the underlying asset whenever the buyer chooses to exercise the option. The underlying asset of options may be shares, bonds, foreign currencies or commodities. Options with shares as the underlying asset are called ‘Stock Options’.
An option that gives the buyer an opportunity to buy shares of a company is referred to as a ‘Call Option’, conversely an option that gives the buyer the right to sell shares of a company is referred to as a ‘Put Option’. One stock option has 100 underlying shares, normally each contract is for 100 shares of a stock in a particular company. Options contracts are sold at various strike prices and expiration dates. The premium amount keeps changing on a daily basis depending upon the value of the underlying asset.
A Call Option Assume that a call option on a particular stock has a market price of $60 and is available for a strike price of $45 for a premium of $5. In this case the buyer could immediately exercise the option by purchasing the shares at $45 and simultaneously selling the shares in the market at $60, thus earning a profit of $15 per share. This call option is referred to as an ‘In-the-money’ option when the strike price is lower than the current market price, since the buyer can earn money if the option is exercised immediately. Considering the same example, the call option would be considered an ‘Out of money option’ if the shares were trading at a market price lower than the strike price. A Put Option Considering a similar example, assume a buyer is holding a put option which gives him the right to sell shares at $50 at the end of the month. If the current market price of those shares is $45, the Put options would be ‘in-the-money’ as the option holder can earn $5 per share by purchasing the shares from the market at $45 and simultaneously exercising the option to sell those shares at $50. The same put option will be an 'out-of-money’ option if the market price moved against the option holder and rose above $50.
By their nature options are very complicated and risky . Two of the most important reasons why an investor purchases options are to speculate or to hedge his existing position in the underlying asset. This article gives a brief overview of options and describes the various advantages and disadvantages of using options as an investment tool.