Definition. Option is a derivative financial instrument, it is a contract sold by one counterparty (option writer) to another counterparty (option buyer). An option gives a right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a fixed price (strike price) over a period of time or on a predetermined date (expiry date).
The owner of a call (put) option has the right to buy (sell) the underlying asset at a strike price. Therefore, the buyer of a call option will make a profit if the price of the underlying asset rises. The owner of a put option has the right to sell the underlying asset at a strike price. Therefore, the buyer of a put option will profit if the price of the underlying asset goes down.
Options are very versatile tools that can be used for different purposes. For example, traders use options to speculate, which is a risky activity. While large investment funds or commodity companies use options to hedge the risk associated with the price movements of assets (for the fund) or commodities (for commodity companies). Read Hedging oil contracts through options - a detailed example. With regard to speculation, option buyers and sellers have conflicting views on the direction and volatility of the underlying asset.
For example, since the writer of a call option will have to deliver shares if the share price exceeds the strike price, the writer of a call option believes that the share price will fall relative to the strike price before the option is exercised.
The buyer of a call option has the opposite point of view. The call option holder believes that the value of the underlying asset will be higher than the strike price. If this happens, the buyer of a call option will be able to buy the share at a lower price (strike price) from the option writer and sell it at the market price.
The call option entitles the buyer to acquire the underlying asset at a fixed price (strike price) for a specified period of time before or on the expiry date.
As an example, let us consider a call option on Microsoft stock. The call entitles the option holder to buy one Microsoft share for $27 within one month. Today the stock is trading at $25. In this case strike price is $27. If we choose to purchase the option, we must exercise it before expiry date. The Microsoft share is the underlying asset.
Call option payoff
What could happen in the next month?
Scenario 1: Suppose the stock remains at the current level of $25. What happens at an expiration date? We could exercise our option rights and pay $27 per share. Would that be the right decision? No, because the share price is $25. So, we would simply not exercise the right to buy, or if we really need a Microsoft share, we could buy it for $25 on the stock exchange.
Scenario 2: What happens if the share price goes up to $29? In this scenario, we would exercise the right and pay the option seller $27 for a share that costs $29 on the stock exchange. The profit from buying a call option would be $2 (minus option premium).
Put gives the buyer of an option the right to sell the underlying asset at a fixed price (strike price) within a specified period of time before or on the expiration date.
Put option payoff
The holder of the put option wants the price of the underlying asset to fall so that he can sell the asset at a higher price than the asset trades on the exchange. The holder of the put will only exercise the right to sell if the share price falls below the strike price.