An option is a financial derivative. Simply said, it’s a financial contract between two parties. These two parties are commonly referred to as the “Long” or “Buyer” and the “Short” or “Writer” / “Seller”. These refer to two opposing sides of the contract. To make it simple for you, we will call them “Buyer” and “Seller”.
There are two types of options: calls and puts.
Calls give you the right to buy the underlying asset at a specific price. Call options increase in value as the underlying asset increases in value.
Puts give you the right to sell the underlying asset at a specific price. Put options increase in value as the underlying asset decreases in value.
Option creation
Anyone can create an option. This is called writing an option. A written option can be sold.
When an option is created, both parties agree to a few details like:
- Strike Price - What price will be used to buy or sell the underlying asset
- Expiration Date - How long does the contract last before it expires
- Premium Price - How much does the Buyer need to pay to the Seller for that Right
- Payment Currency - What currency can be used to purchase or sell the asset
Once the two parties have agreed, and the Buyer has delivered payment to the Seller (paid the premium), the Option is considered open, and a binding contract has been formed.
Buying and exercising an option
When you buy an Option, you own it. When you own an option, and anytime before its expiration date, you have the right to buy (call) or sell (put) the underlying asset at the strike price. Doing so is called exercising the option. You may also choose to resell your contract again for a premium. By selling your previously owned Option, you no longer have the right to exercise the contract. In short, as a contract buyer, you have rights.
Selling an option
You can sell both calls and puts. When you sell an Option you wrote, you are obligated to fulfill the contract should it be exercised. You can sell both calls and puts. That means you can be forced to buy (put) or sell (call) the underlying asset at the strike price. In short, as a contract seller, you have obligations. However, you can always try to buy back an option identical to the one you sold, to no longer be tied to those obligations. When an option you wrote has expired, you can close the position and return the underlying assets you provided.
Option prices
Options are priced based on two general ideas, intrinsic and extrinsic value. The intrinsic value is the difference between the asset price and the strike price and only exceeds 0 when the option is “in the money”. Extrinsic value can be derived from several mathematical equations, but broadly speaking is based on the time value of the option (i.e., how much time is left before expiration) and the asset's volatility.
