An options contract is ‘The right, but not the obligation, to buy or sell a specific amount of a given stock, commodity, currency, index, or debt, at a specified price during a specified period of time.’ Options are ‘derivatives so called because they derive their value from an underlying asset, such as a stock, bond, interest rate or commodity.’
A put option, gives the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option which gives the holder the right to buy shares.
The strike price is the price at which the spot price must go above for calls or below for puts before the position can be exercised to make a profit. For a European option this must occur on the expiration date, for American options this can occur any date up to expiration date. American options therefore have more flexibility and to take this into account American options cost more in the form of the premium.
The purchase price of an option is the premium. The main thing affecting the option premium is the difference between the stock price and the strike price. Additional primary factors affecting the option premium include the time remaining for the option to be exercised and the volatility of the underlying stock.
An option contract has a buyer (holder), and a seller(writer). If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. For the holder, the potential loss is limited to the premium, and the profits are unlimited. Option contracts, like stocks, are therefore said to have an asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security underlying the option. The upside is that if the contract expires they gain the premium.
The two main reasons for...