You need to understand what options are. Here’s what to know.

What are options?

An option is a derivative contract in which an investor has the right, but not the obligation, to buy or sell a tradable asset at a specified price at a given time in the future. They are very similar to futures contracts, except that they are “optional,” hence the name; futures involve the obligation to buy or sell an underlying asset.

Deeper definition

Investors use derivatives such as options and futures to manage risk, to speculate and to obtain leverage. They are “derived” from an underlying asset. With options, the underlying asset is most often stock, although they are also used to trade currencies, bonds and ETFs, among other securities.

The party who creates an option contract is said to write the option, and charges the other party a fee, or a premium, to enter the contract. The writer of an option commits to buy or sell an asset at a preset price, called the strike price. The option is considered live until an expiration date, when it terminates. The writer must buy or sell a security if it reaches the strike price, when the holder can exercise the option, but if the expiration arrives before the strike price is reached, the writer keeps the premium and no exchange takes place.

In practice, fewer than 10 percent of options are ever exercised, while the vast majority are either traded or expire worthless. The price of the premiums charged for options fluctuate as the value of the underlying securities change, and the contracts are resold on exchanges like the Chicago Board Options Exchange (CBOE), giving investors the ability to get leverage and speculate on the direction of trading in the underlying assets.

Options contracts come in two categories: puts and calls. Puts give the holder who buys the option the right, but not the obligation, to sell assets to the writer of the option once the agreed-upon strike price is reached. With puts, the holder believes the underlying asset’s price will fall below the strike price before expiration. Calls are the opposite: holders have the right, but not the obligation, to buy assets if the strike price is reached before expiration. With calls, the holder thinks the asset’s price will rise above the strike price.

There are a variety of different kinds of options, including:

  • Weekly Options
  • Mini-Options
  • Index options
  • Binary Options
  • Options on Futures
  • ES Weekly Options
  • E-Mini Options
  • ETF Options

Trading in the options market is only for experienced market participants. Looking for a simpler way to make money? Check out these great money market rates.

Options example

Englebert has a portfolio of stock that includes hundreds of shares of Dynaco Machines Corp. In order to boost his income, he writes call options on his favorite stock, Dynaco, and sells them on the CBOE. Dynaco is currently trading at $125 a share, so Englebert writes a call option that gives the holder the right, but not the obligation, to purchase 100 shares of Dynaco at a strike prices of $150, with an expiration date three months out. Englebert is charging a premium of $2 per share (x100 = $200) to buy the option.

If shares of Dynaco rise above $150, the buyer of the options wins and Englebert is obligated to sell 100 shares to the holder for $150. But if they never hit the strike price of $150, Englebert wins and gets to keep the $200 premium the buyer paid. If shares of Dynaco get closer to the strike price of $150, the buyer can resell the option and make a profit off his speculative bet, but if shares of Dynaco decline – widening the spread between the strike price and the underlying asset price – the price of the option falls.

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