An Option is a financial derivative that represents a contract between two parties; one party is the option writer and the other party is the option holder. The person holding a option has the right but not an obligation to buy or sell a security or other financial asset at an agreed-upon price during a certain period of time or at a specific date .In other words,a Option gives a choice to the holder of it which may either be to buy or sell at the price and time specified at a time,hence as the name says it gives a you an option to purchase at a price other than price at which the stock is being traded at a market.
A Option is quite flexible than a futures or forwards so normally a premium or a fee is charged for the contract before it is issued.A trader can basically use it for two functions either to hedge or to speculate.In general terms it can be understood that their is a conflicting views in regard of the performance of the underlying asset.Options are exchange traded and available to both institutional and retail investors.
A Call options gives the holder the right to buy the underlying asset at a fixed price with an expiry date.The price at which the option call be called is called the strike price.If someone is speculating the price to go up then he can buy this option so that he can later on buy it at a lower price and earn the profit but they have to pay a premium to start the contract.They can exchange the asset or can pay the difference between the market price and the strike price.
Put options give the option holder right to sell at a certain price with an expiry date.If the price of the underlying asset in falling then the holder has the right to sell the writer of the option the underlying asset at the strike rate.They can either choose to exercise the assets or can pay the difference between the strike price and market price.
A call and put option are voluntary and one can choose to either execute it or not depending upon the situation.A call option will not be executed if the market price plunges as no one at their right sense would buy at a price higher than the market price and a put option will not be exercised if the market price is more than the strike rate as people would rather sell at a higher price than the strike price.This is what the writers speculate on happening and hence issue the options.
The price of the premium changes in a Option as the price of the underlying asset changes.In other words,the premium for a call option will increase if the price of underlying asset is increasing and the premium for put option will increase as per the drop of the underlying asset and this is the reason why a Option is a derivative.It can be traded in the exchange market and the prices (premium) would change as the change in the underlying asset.