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  6. What Is An Option

    An option is a contract between two parties, in which one party gives the other party the right to buy or sell a defined amount of a security, in a defined time frame at a defined price. The other party has an obligation to deliver or take delivery of the security, from the counterparty, at the defined price.

    These rights, or options contracts, are mostly traded on exchanges.  For example, the Chicago Board Options Exchange and the Philadelphia Stock Exchange are places where different option contracts trade. They also primarily are for the right to buy or sell stocks or ETFs. The security whose right to buy or sell is being traded is called the underlying security.

    A call option is the right to buy an underlying security. A put option is the right to sell an underlying security. The buyer of the right pays what is called a premium to the seller. The seller of an option contract is said to have wrote an option contract. The price at which the underlying can be bought (in the case of a call option) or be sold (in the case of a put option), is called the strike price.  The date that this right expires is called the expiration date. The act of the buyer of an option contract implementing his or her right upon the seller, is called exercising the option. Usually, one contract controls 100 shares of stock.

    If you buy a call option, you want the price of the underlying stock to go up and be above the strike price on the expiration date. This is because you can buy the shares at the strike price, which is lower than where they are trading in the market. You could then sell the shares at the higher price and make a profit. Obviously, the seller of a call, or the person that wrote the call option, does not want the stock price to go above the strike price. This is because he or she will need to go out and buy the shares at the higher price in the market in order to deliver them in exchange for the strike price, which is lower, to the person who bought the call option.

    Conversely, if you bought a put option, you want the price of the underlying stock to go down and be below the strike price on the expiration date. This is because you can buy the shares at a lower price in the market and then exercise your put option and sell them to the person that wrote the option at the higher price. The person that wrote the put option does not want the underlying to go down below the strike price at expiration. This is because he or she will need to purchase it at the higher price, when the owner of the put exercises the option contract. 

    Because one option contract controls 100 shares of stock, options utilize what is called leverage. This is when a small amount of capital controls a larger amount of assets. Leverage exaggerates your gains and losses. This can be positive if the price moves with you and negative if it moves against you.

    For example, if you buy a call option for 2 you pay 2 times 100 or $200. If the price of the call goes to 5 and you sell it, you get 5 times 100 or $500. you made $300. If the price of the call goes to 1 and you sell it, you get 1 times 100 or $100. You lose $100.

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