The right to buy or sell a certain quantity of an underlying instrument (e.g. shares) from the option writer at an agreed-upon price (exercise price) within a certain period of time or on a specified date. The right to buy the underlying instrument is a call; the right to sell it is a put.
Options are financial instruments in their own right. They belong to the class of instruments known as derivatives, which are traded either over-the-counter or as standardised contracts on an options and futures exchange. The buyer of an option pays the option writer a price (premium) for the right to exercise the option. In return, the option writer is obliged to deliver or accept the underlying instrument in exchange for payment of the agreed-upon price when the option is exercised. If the option owner does not exercise the option, it expires at the end of a specified period. Because the decision to exercise an option rests solely with the buyer, this class of derivative is also called a contingent forward deal.
Purchasing options enables investors to take advantage of expected upward trends in the cash market or hedge against risks. The two classic option contracts are the long call (purchase of a call) and the long put (purchase of a put):
An investor expects stock A to go up. By purchasing a call, he acquires the right to buy this stock in six months' time at a price of €100 (the exercise price). He pays an option premium of €5 per share. If, at the end of the six-month period, the price of the stock has increased to, say, €108 (in which case the option is said to be "in the money"), the investor will exercise his option; in other words, he will buy the shares from the option writer for €100 and then sell them immediately on the market for €108. In this example, his profit -- the price of the share less the exercise price and the premium -- would be €3. If the stock price had been €105, the option would have been at the break-even point, and the investor would have neither earned a profit nor incurred a loss. If the market price of the stock is at the exercise price ("at the money") or below it ("out of the money") at the time of expiration, the investor will normally let the option expire, because he would lose money by exercising it.
The purchase of a long put often serves as a strategy for hedging against losses. For example, an investor owns stock B, whose current price is €45. Because he expects prices to fall, he wishes to protect himself against a possible loss. He buys a put with an exercise price of €48 and pays the option writer a premium of €3. If the price of the stock has dropped to €40 at the time of expiration, the investor will exercise his option. He sells his shares and receives €48 per share. After deducting the option premium of €3, he retains €45, thus preserving the value of the stock.
