An option is a financial instrument that offers you the right – but not the obligation – to buy or sell an asset when its price moves beyond a certain price with a set time period.
They exist in the form of a contract, between the writer and the holder. The price at which the holder can exercise the option is referred to as the strike price.
There are two types of option:
- Calls give the holder the option to buy an asset at or above the strike price
- Puts give the holder the option to sell an asset at or below the strike price
In options trading, the writer of the option makes a profit if the asset involved does not meet or move beyond the strike price, because the holder has to pay a premium in order to buy the option. The holder makes a profit if the asset’s price moves beyond the strike price by more than the premium they initially paid.
Options tend to trade in lots, with the size of the lot varying depending on the type of option. In equity options, for instance, each contract represents 100 shares of the stock underlying the option.
Options can be used to both speculate on the movements of markets and hedge against already open positions.