What is an Option?

Options are different from normal transactions between two parties. Normally when people purchase an item, the buyer receives the item at the agreed upon price. The seller gives the buyer the item, and the transaction is finished.

An option, on the other hand, doesn’t allow someone to buy an item. With options, they are buying the right to buy, or sell, the item. More formally, an option is a formal agreement or contract between two parties to either buy or sell an asset, known as the underlying, for an agreed price, known as the strike price. The underlying can be either a single stock or a collection of stocks. There is a cost, known as the option premium, for entering this contract. The buyer of the option pays this premium to the seller. Thus, for the buyer, there is a net debit. For the seller, there is a net credit. Once the contract is formed, the option buyer has the right, or option, to go through with buying or selling the item. If (s)he so chooses, the seller must fulfill the obligation.

Options differ from normal transactions in another way - they also have a timeline. This is the period of time for which the buyer can go through with, or exercise, the option. The date at which the option no longer valid is known as the expiration date.

Options come in two varieties: Call and Put. A Call gives the buyer the right to buy the underlying, at the strike price, before expiration. A Put gives the buyer the right to sell the underlying, at the strike price, before expiration.