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Introduction to Options

An option is a derivative instrument that gives its holder a right to buy or sell an asset, at a set price (the strike price) on a set date (contract expiration).

A call option gives its owner the right to buy; it is not a promise to buy. For example, a store holding an item for you for a fee is a call option.

Assume that you want to buy a stock after three months, currently trading at $100, but feel that the price of the stock will rise significantly. In this case, you can buy an option on the stock to buy the stock after three months at a price fixed today (say $120). After 3 months, if the spot stock price has actually risen above $120, you can exercise the option and get the stock at $120. If however the actual stock price doesn’t rise as expected (say it rises only upto $110), then the investor need not exercise the option and let it expire. He can instead buy the stock directly from the market at $110.

A put option gives its owner the right to sell; it is not a promise to sell. For example, a lifetime money back guarantee policy on items sold by a company is an embedded put option.

In the U.S., stock options are standardized and traded over exchanges (unlike a forward contract or a swap, which are private over-the-counter instruments).

Just like a stock or a bond, an option is a binding contract with strict terms. The option buyer is required to pay a premium at the beginning to buy the option.

Options can be of two types: European and American.

European Options: European option contracts are the ones that can be exercised only at expiration.

American Options: American option contracts are the ones that can be sold at any time prior to expiration.

An option contract can be based on various underlying securities such as stocks, indexes, and bonds. Stock options are the most commonly traded option contracts. In general, one option contract is for 100 shares of stock.

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