What Are Options?

An option is a contract between two parties in which the buyer has the right (but not the obligation) to buy or sell a specified asset at a specified price at (or before) a specified date, from the seller. The seller of the option is obligated to transact if the buyer exercises that right.

The buyer of the option is not obliged to complete the deal. The option protects the buyer from unfavorable market conditions. However, if changes in price are in the buyer’s favor, buyer could make a profit by completing the deal. The risk of loss is carried by the seller. For that reason, seller charges the buyer a fee and this fee is called the premium.

This feature distinguish an option contact from other instruments such as forward contracts or future contracts, in which both parties to the contract have an obligation to transaction at some time in the future. In an option contract, only the seller has an obligation to transact. However, this is only if the buyer requires the seller to do so. The act of enforcing the buyer’s rights under an option contract is called exercising the options.

Options create a legal relationship between the buyer and the seller of the option contract. This relationship can remain in place until the option is exercised. It is allowed to lapse if the option is not exercised prior to or on the expiration date. Besides, it is possible for buyer and seller of the option contract to enter into an ‘opposite’ contract and for these contracts to be offset against each other.

Option Buyer

The person who buys the option has right, but not the obligation, to do either buy the underlying asset (in case of an call option) or sell the underlying asset (in case of an put option). Buying an option is sometimes referred as taking an option. The buyer is also called the taker.

Option Seller

The seller of an option is obligated to either sell the underlying asset (in case of an call option) or buy the underlying asset (in case of an put option). Seller is in the opposite position of the buyer. Selling an option is sometimes referred as writing or granting an option. The seller is also called the writer or grantor.

Related posts:

• Preparing for Trading Options
• Putting Your Money in the Market with a Put Option