In finance, options are a kind of contract or we must say a derivatives contract by nature. It is the kind of contract which gives the buyer or the owner the right, but not the obligation, to buy or sell any underlying asset at a predetermined price and on or before a specified date, respectively. Unlike futures contract, which makes it an obligation to buy or sell the asset, options gives the buyer or seller the right to buy or sell, but no rigid obligation to do so.
If the buyer chooses to exercise his right then the seller comes under the obligation to fulfil the transaction. In option contracts, the buyer or seller do not buy or sell the underlying asset, instead they buy the right to buy or sell the asset, that is, rather than getting into the obligation to make the transaction they just buy the right to do so until the expiration period. Since the buyer has an upper hand in these kinds of contracts, he has to compensate the seller for it, and he does so by paying the seller a premium.
Two terms to understand now-
- Call option- An option which conveys to the owner the right to buy the underlying asset at a specified price and until the specified period, is known as the call option.
- Put option- An option which conveys the right of the owner to sell something at a specified price and until the specified period, is known as the put option.
Since options contracts are kind of derivatives contracts, they are also of similar two types-
- Exchange traded options- These are the ones, the trade of which happens when the transaction goes through an exchange. The terms of this contracts are fixed and a standardized procedure is followed
- Over the counter options- These are the ones, which are traded privately among the parties, and the transaction not necessarily needs to go through an exchange. The terms of contract can be altered to some extent on mutual agreement. Generally, one of the parties involved in it is a well-capitalized institution.