Key Takeaways
An option is a contract that gives its holder the right to buy or sell a specific security on a specific time at a specific price.
There are five basic factors of a standard option: underlying instrument, Strike price, expiration date, contract type and premium.
Understanding an Option
An option is a contract that gives its holder the right to buy or sell an underlying asset on a specific time at a specific price. There are five basic factors of a standard option:
1. Underlying instrument. An Option's price is derived from the underlying instrument which it tracks. The underlying instrument could be stocks, market indices, exchange-traded funds, bonds, currency, interest rates or futures contracts.
2. Strike price. Strike price is the price at which the buyer of the option contract able to buy or sell the underlying instrument. It is also known as the exercise price. Strike price is important because it helps traders to price the value of the option. If an option's underlying instrument can be bought or sold at the strike price to make money, the option has an intrinsic value.
3. Expiration date. Expiration date is the date on which the option you're able to exercise the option. It determines the time value of the option. When an option reaches its expiration date without being exercised, it becomes worthless. Based on whether if an option can be exercised before expiration date, there are two types of options: American options and European options. American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date.
4. Contract type. There are two types of option Contracts: Call Options and Put Options, you may often heard these as "calls" and "puts". Calls and puts are the opposite of each other. Calls give the buyer the right to buy the underlying asset at the strike price specified in the option contract. On the other hand, Puts give the buyer the right to sell the underlying asset at the strike price specified in the contract.
5. Premium. An option premium is the price paid by the buyer to the seller for an option contract, or the current price of an option contract that has yet to expire
