An option is a contract between two parties – a buyer and a seller – that gives the buyer the right, but not the obligation, to purchase or sell something at a later date at a price agreed upon today.
An Option is a derivative contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price – to the buyer of the Option.
While buyer of option pays the premium and buys the right, writer/seller of option receives the premium with obligation to sell/ buy the underlying asset, if the buyer exercises his right.
These may sound simple products, buy we need to understand them in detail before entering into one ourselves.
It may become tempting to write an Option (Sell an Option contract) and enjoy the upfront premium – but the liability of the Option seller is Unlimited and his profit is only limited to the Upfront premium enjoyed by him.
For an Option buyer, he may be paying upfront premium – and it may sound like his profits are further reduced with the amount of premium paid by him. But derivative contracts are primarily for hedging oneself and not for speculation. Even though the Buyer of an Option contract may have to pay an upfront premium, his losses are limited to the upfront premium he has paid and his profits are unlimited depending on the way the market moves impacting the price of his underlying instrument.
The option buyer pays the seller (of the Option) a sum of money called the price or premium.
The option seller stands ready to sell or buy according to the contract terms (the underlying) if and when the buyer so desires.
An option to buy something is referred to as a call; an option to sell something is put.
Hence the Option to buy (Call Option) can be sold or bought.
And Option to Sell (Put Option) can be sold or bought.
So Four situations can be created using Call and Put Options:
Note: Watch the video below on Introduction to Options (Financial Derivatives):