In finance, an option is a derivative that is generally a contract between two parties. It gives the right, but not the obligation, to buy or sell a specific amount of an asset at an agreed price on, or before, a given date.
Investors not companies issue or write options. An option has a buyer, called the holder, and a seller, who can be called the writer.
If the option is not exercised by the stated date it is worthless and the money paid, known as the premium, is forfeited.
Options can be issued on stocks, commodities, currencies, indexes and debt.
For instance, suppose you believed the price of gold will continue its ascent and you wanted to take a very large investment position.
Gold is now trading at approximately US$1,415 per ounce. You have only $10,000 to invest so that would only allow you to purchase 7 ounces.
If the price of gold increases $100 an ounce over a one-year period and you sold it, the profit would be $700, or a 7 percent return.
Another investor in gold has a large position of 700 ounces and is concerned the price may drop and wishes to mitigate the risk of a price decrease.
The investor offers to sell you an option to buy the full or partial position anytime during the next 12 months at a price of $1,415 per ounce in return for giving him $14.28 per ounce today.
A significant profit can be gained on a small investment
For the same $10,000 you now have an exposure to a position of 700 ounces.
If the price of gold gains $100 per ounce, your potential profit would be $85.72 an ounce, or $60,000, a 500 percent return.
However if the price remained under the agreed contract price of $1,415 per ounce, you would lose the $10,000 as the option would expire after one-year with no value. The investor who sold the option would pocket the $14.28 per ounce, or $10,000 either way.
This contract has achieved two distinctive purposes. The buyer of the option has the ability to leverage a speculative position on gold. The seller of the option has a means of mitigating a decrease in the price of gold.
Standard options have defined characteristics. An option to purchase the underlying property is a call option and an option to sell is a put. The specified price agreed to either buy or sell is known as the strike or exercise price.
Options are issued for an agreed period time, allowing the buyer to exercise their right during this period or at a specific date. The writer of an option receives a premium or payment in return for granting the option.
Options traded on an exchange are known as listed or exchanged traded options. Over-the-counter options are traded between two private parties and usually involve an intermediary such as an investment bank.
Options can be either highly risky or act as an excellent means of hedging. As in the example above, a significant profit can be gained on a small investment, or that investment may be completely lost.
As with any investment, it is essential to understand the investment and the risk and returns it offers.