What is the meaning of options?

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pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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In terms of business and investing, options are a type of investment in which a buyer pays for the right to buy or sell some given asset at a particular price on or before a particular date.

For example, you could buy an option, for instance, to buy 1 million barrels of oil at $70 per barrel on January 1st of next year.

So why would you do this?  The main reason is that you would be betting that the price of oil would actually be higher than that on January 1.  If it is, you can make money.  Let's say the price of oil on that date is $100 per barrel.  You can buy your 1 million barrels for $70 each and turn around and sell them for $100 each.  Right away, you make $30 million.

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william1941's profile pic

william1941 | College Teacher | (Level 3) Valedictorian

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An option is a contract between two parties, which gives the party which owns the option the right, but not the obligation, to buy or sell something, from or to, the party which sold the option, in the future.

Whatever can be bought or sold using an option is called the underlying instrument. Also every option has a price, called the strike price, at which the underlying instrument can be bought or sold.

To understand this lets take an example. You have bought an option to buy stock of company A, (which is also called a call option) from another person which is valid for the next three months and which has a strike price of $2. This means that if you express the desire, the other person has to sell stock A to you at $2. You would use this option if the prevailing market price of stock A is more than $2. That way you can later sell it and make gains. If the stock price does not exceed $2, there is no point in using the option. The agreed upon price, the call price (100 shares at $2), is termed the premium.

Options are one of the many instruments called derivatives which help people manage risk better and also try to make profits based on the change in price of different assets.

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