An option is a type of financial derivative contract that provides the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (also known as the strike price) within or at a certain time in the future. The two main types of options are calls and puts:
- Call Option: This gives the holder (buyer) the right to buy an asset at a specified price within a specific time period. Buyers of call options bet that a stock’s price will increase before the option expires.
- Put Option: This gives the holder (buyer) the right to sell an asset at a specified price within a specific time period. Buyers of put options bet that a stock’s price will decrease before the option expires.
Here’s how it works:
- The person who buys an option pays a premium to the person who sells (also known as writing) the option.
- The buyer of a call option hopes the price of the underlying asset will rise before the option expires, while the buyer of a put option hopes the price will fall.
- The seller, in contrast, hopes for the exact opposite: for the price to remain stable (or, in some cases, for it to move in the opposite direction of what the buyer hopes).
Options can be used for various purposes, including hedging (reducing potential losses), speculating (attempting to predict future price movements to make a profit), or allowing one to adjust the return characteristics of one’s portfolio. Options are traded on various underlying assets, including stocks, bonds, commodities, currencies, and indices.
Example of an Option
Let’s look at an example of a call option:
Imagine you think the stock for a company, say Company XYZ, currently trading at $50, will go up in the next two months. You could buy a call option that gives you the right to buy 100 shares of Company XYZ at $50 anytime within the next two months. This call option might cost you $2.00 per share, so your total investment (known as the premium) would be $200 (since options contracts typically represent 100 shares).
Here are the two main scenarios:
- If the stock price goes up: Let’s say the stock price rises to $60. As the call option holder, you have the right to buy 100 shares of Company XYZ at $50 per share, even though it’s currently trading at $60. This means you could buy the shares for $5,000 and then sell them for $6,000, making a $1,000 profit. However, don’t forget you paid $200 for the call option, so your net profit would be $800.
- If the stock price goes down or stays the same: If the stock price falls below $50, or doesn’t move at all, buying the stock at the strike price of $50 would not be profitable because you could buy it for less on the open market. In this case, you would likely choose not to exercise your option to buy the shares. The call option would expire worthless, and your loss would be the $200 you paid for the option.
Remember, this is a simplified example and doesn’t include factors such as transaction costs. But it shows the basic concept of how a call option works. The put option works similarly but in the opposite direction – you’d be betting on the price going down instead of up.