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Lesson 2:

What is an option?

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An option is a financial contract that grants the buyer the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price within a specific period. When you purchase an option, you're essentially paying a 'premium' to the seller for this right. This premium is the price of the option, and it's determined by various market factors.

Each option contract is defined by its particular terms, which specify the number of shares involved, the type of underlying asset (like a stock or commodity), the strike price (the agreed-upon price at which the asset can be bought or sold), and the expiration date. The expiration date is crucial because it's the final day the option can be exercised; after that, the option no longer exists and has no value. Understanding these terms is key to grasping how options work and how they can be used in trading.

Lesson 2: What is an option?

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Options contracts are categorized as either call or put options, which give the owner the right (but not the obligation) to buy or sell the underlying security. A call option grants the buyer the right to purchase an asset, while a put option gives the buyer the right to sell it. The seller of the option contract is required to fulfil the terms of the contract. The holder of an option has the power to enforce the contract's terms, but it's the seller who must honor them.

Lesson 2: What is an option?

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An Option can follow one of three paths:

  1. Exercised
    • The buyer activates the rights outlined in the contract to buy (for calls) or sell (for puts) the underlying asset.
  2. Expired
    • If the option isn't exercised before the expiration date, it ceases to have any value or obligations.
  3. Traded
    • Options can be bought or sold in the market before they expire, which is often where much of the options trading activity occurs.

Lesson 2: What is an option?

Understanding these outcomes is crucial for traders, as each carries different implications for the value and management of the option contract.

Here is an example of a call option, let’s assume Jan 24th is 30 days from now:

buyer seller chart

This contract is a call option, meaning it grants the holder the right to purchase a specified asset. In this case, the asset is stock in company XYZ. The terms of this call option contain the right to buy 100 shares of XYZ at a price of $100 per share anytime up until January 24th (30 days to expiration or DTE). The cost of acquiring this right is $5 per share. Since each options contract typically represents 100 shares, the total premium paid for this contract is $500.

As the holder of the call, the buyer is speculating on the stock's price increase. The more the price of XYZ rises, the more valuable this option becomes. Should the buyer decide to exercise the option—meaning to buy the shares at the agreed price of $100 per share—the seller is required to sell them at this price, an obligation known as assignment.

Helpful Tip

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Lesson 2: What is an option?

Key Takeaways

1. An option is a contract between a buyer and a seller. The buyer pays for the right to execute the contract's terms, while the seller receives an up-front credit and is obligated to fulfil the terms of the contract.

2. An option buyer intends for the option to have as much executable value as possible. The option seller does not want the option to have executable value.

3. A call option gives the buyer the right, but not the obligation, to buy a specific asset at an agreed price before the contract expires.

4. A put option gives the buyer the right, but not the obligation, to sell a specific asset at an agreed price before the contract expires.

Click “NEXT” to check your knowledge

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Lesson 2:

Knowledge Check

Lesson 2: What is an option?

Knowledge Check

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What does the premium of an option represent?

(Select an answer below)

Lesson 2: What is an option?

Knowledge Check

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Which of the following best describes a call option?

(Select an answer below)

Lesson 2: What is an option?

Knowledge Check

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If an option contract is not exercised before its expiration date, what happens?

(Select an answer below)

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Congratulations!

You have completed The Foundation - Lesson 2:

What is an option?

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