A Financial Option is a Contract between two parties that gives the Right to Buy or Sell an Underlying Security at a predefined Price for a limited Period of Time.
What is an Option Contract?
In an Option Contract there are two parties involved.
- The Buyer of the Option
- The one who pays the Option Price or Premium
- The one who collects the benefit (if any)
- The Seller or Writer of the Option
- The one who collects the Option Price or Premium in advance
- The one who assumes the Risk
What are the Rights involved in a Financial Option?
In a Financial Options there are two different Rights:
- The Right to Buy: They are referred to as “CALLs.”
- In Calls:
- The Buyer wants to make sure he/she will be able to BUY at a predefined Price in the Future.
- The Seller assumes the Risk of having to SELL at a predefined Price in the Future.
- In Calls:
- The Right to Sell: The are referred to as “PUTs.”
- In Puts:
- The Buyer wants to make sure he/she will be able to SELL at a predefined Price in the Future.
- The Seller assumes the Risk of having to BUY at a predefined Price in the Future.
- In Puts:
What are Options Underlyings?
Stock Options are very popular. They are traded in public markets and both professional and retail investors can buy or sell them. But they are also popular as a way of retributing employees, especially in tech companies.
In the case of Stock Options, the Underlying would be shares of a public company. But there are also options for other underlyings such as:
- Commodities (oil, gas, gold, …)
- Currencies (EUR/USD, USD/JPY, …)
- Indexes (S&P 500, DAX, …)
What is the Option Strike?
The Option Strike is the predefined Price at which the Option Contract gives the right to buy or sell.
- In CALLs
- The Buyer of a CALL wants to make sure he/she will be able to buy at the Strike Price in the Future.
- The Seller of a CALL assumes the risk of having to SELL at the Strike Price in the Future.
- In PUTs
- The Buyer of a PUT wants to make sure he/she will be able to sell at the Strike Price in the Future.
- The Seller of a PUT assumes the risk of having to BUY at the Strike Price in the Future.
What is the Expiration Date?
The Expiration Date in an Option is the last date or the unique date in which an option contract can be exercised.
What is the difference between American and European Types of Options?
Based on the possibility of exercising an Options Contract before the Expiration Date, there are two types of options:
- American Options: They can be exercised at any time till the Expiration Date.
- European Options: They can be exercised ONLY on the Expiration Date.
Note that even being called in this way, the type of an option does not depend on whether it is traded in America or Europe or whether its underlying is based in one of these countries.
What is the Option Price or Premium?
The Option Price is the price at which the Buyer and Seller agree to formalize the Option Contract.
It will be paid by the Option Buyer to the Option Seller.