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The Basics of Options

• Either buy or sell a specified quantity of a specified asset which can be almost anything such as commodity options, precious metal options, currency options, stock options, bond options or futures contract. The asset upon which an option is based is called underlying asset (or security).
• At a certain price (the strike price). The price of an option itself is called its premium. The premium is the means by which the buyer compensates the seller for his willingness to grant the option.
• Up to a specified point in time (the expiration date which is the last day on which an option can be exercised or offset). An option which is left unexercised expires worthless after a stated period of time.

• Call options: that allow the investor the right to buy the underlying asset.  For example, a call option on an underlying asset gives the buyer the right, but not the obligation, to call the asset away from the seller of the call option.  The seller of a call option receives the option premium but, in return, must sell the underlying asset to the option holder if the holder exercises the option. As the price of the underlying interest rises, a call option increases in value. This accrues as a gain to the option buyer and a liability to the option seller.

• Put options: that allow the investor the right to sell the underlying asset. For example, a put option on an underlying asset gives the buyer the right, but not the obligation,to put the asset to the seller of the put option. The seller of a put option receives the option premium but, in return, must buy the underlying interest from the option holder if the holder exercises the option. As the price of the underlying interest falls, a put option increases in value. This accrues as a gain to the option buyer and a liability to the option seller.

Example: Assuming that listed options trade on XYZ, Inc., you can buy an "XYZ 40 call" option. This option gives you the right to buy 100 shares of XYZ, Inc. any time on or before the option's expiration date at a price of $40 per share. Let us also assume that the premium of this option is $400. The seller of this option receives the $400, in exchange for standing ready to sell you 100 shares of XYZ, Inc. for $4000 anytime you choose to buy it until the option expires. Forcing the seller to honor the terms of the option contract is called exercising the option. Assume you buy the option and the price of XYZ rises to $50 a share within the next six months. You may exercise the option and then sell the same shares in the open market for $50 per share. Thus, you have made a profit. You receive the net profit of $600, [($5000-$4000) - $400) resulting in a 150% profit.