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What is an option?

Learn more about option

An option is a financial instrument giving the right, but not the obligation, to buy or sell an asset, such as a share or currency, for a predetermined price at a fixed future date. Options are a type of derivative.

Based on the underlying securities, such as stocks, option contracts can be of two major types:

  • Call options allow traders to BUY the underlying asset at a specified price within a specified time period;

  • Put options allow traders to SELL the underlying asset at a specified price within a specified time period.

An option is a future opportunity to buy an asset priced today. If the price is lower than it is today, the option can be allowed to expire. That means the investor or trader loses only the original cost of the option. If it is higher, the option-holder makes a profit.

Where have you heard about options?

Periods of market volatility are sometimes blamed on the trading of options and other derivatives. Others say, however, that these instruments — so named because they are “derived” from an underlying asset (e.g. a share or a commodity) actually work to smoothen market movements by allowing traders to hedge their positions. 

What you need to know about options.

Options meaning presupposes that you are not required to do anything and can even let the contract expire, without taking further action. Before diving into options trading, you should learn some basic terms, including: 

  • Premium: a price at which you can buy and sell options;

  • Strike price: a predetermined price of the asset at which it may be bought or sold according to the option contract;

  • Expiration date: the end date of the option contract. 

Traders buying option contracts are called holders, while those who sell them are called writers. Call and put option buyers — holders — do not actually have to buy or sell. This feature helps traders limit the risks to the premium that they already spent.

Call and put sellers — writers — are obliged to buy or sell if the option expires in-the-money. It means that option writers are exposed to higher risks. 

Standard option contracts usually consist of 100 shares of the underlying stock, and the buyer is supposed to pay a special premium fee for each contract. For example, if an option premium is 50 cents, you’ll have to pay $50 for one option contract ($0.50 x 100 = $50).  

Investors and traders have several reasons to add options to their portfolio. Sometimes option contracts are used for hedging purposes, in order to reduce overall risk exposure. Sometimes they are used for speculation. In some businesses, options are used to give managers an incentive to work harder and drive up the share price.

Options and other derivatives are generally not a good choice for an amateur investor and should be left to professional traders.

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