An option contract gives you the right, but not the obligation, to buy or sell an asset at a price. You cannot buy or sell this asset either at a pre-determined time in the future or any other time till it reaches the maturity. Generally, one option contract stands for one hundred shares in the underlying stock. An option contract always has a buyer, who is known as the holder, and a seller or writer. In order to exercise the option contract, the writer has to complete the formalities of the contract by giving the shares to a suitable party. In a few cases, like an index where a security cannot be delivered, the option contract is settled in hard cash. If you don’t exercise the option it expires, but the holder’s loss is limited to the money he shells out to take up the option. After the option expires there can be no trading of shares, but the buyer gains from this deal and the writer loses considerably unless the contract is covered. Hence, similar to stocks, the payoff pattern of the option contract is asymmetrical. Usually, option contracts are used as leverage or protection. As leverage, the option enables the holder to have control over the equity in a smaller capacity. The control is just a fraction of the actual value of the shares. The amount saved from the difference can be intelligently invested in other, more lucrative, alternatives until the time option is exercised. Options can provide protection against the dynamic price fluctuations in the market, as they give the right to hold the underlying stock at a pre-determined price and for a given duration. Barring the issue when writing options for a security is not owned, the risk involved is not very high, and is limited to the option premium. Nonetheless, the price of trading options is high if we deal on a percentage basis, as compared to trading the underlying stock.
