What are Options?

Options are derivative securities, which give the holder the right, but not the obligation, to buy or sell another instrument at a fixed price before or at a fixed expiration date.

There are two types of options:

Call Options

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.

Put Options

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.

Each option contract has a limited life and can be exercised within that life. Based on the expiration, options can be categorized as American or European. An American option gives its owner the right to exercise the option anytime prior to option expiration. A European option may only be exercised at expiration. There are also Bermudan options where the holder can exercise every n months up until the expiration date.

Options can be created with a variety of underlying assets. Options giving the right to buy or sell shares of stock (stock options) are the best-known options. Generally, an option contract is for 100 shares of stock. There are also index options, where the underlying asset is some market measure like the S&P 500 index. Index options are cash-settled. Apart from that there are other options such as commodity options, FX options, and options on other derivatives, among others.

Characteristics of an Option Contract

An option contract has the following characteristics:

Expiration dates: The Saturday following the third Friday of certain designated months for most options.

Striking price: The predetermined transaction price, in multiples of $2.50 or $5, depending on current stock price.

Underlying security: The security the option gives you the right to buy or sell

Both puts and calls are based on 100 shares of the underlying security.

Option premium: The option premium is the amount you pay for the option.